Investment Policy, Optimality, and the Mean‐Variance Model

THE MEAN-VARIANCE APPROACH to the analysis of securities market performance has en-abled researchers to summarize the performance of securities in terms of easily interpretable parameters and to develop and test hypotheses concerning the relative values of securities. While most of these studies treat the investment decisions of firms as exogenous, the model may also be used to characterize the optimal investment decisions of firms. The central methodological step in the determination of the optimal investment policy, given mean-variance preferences and homogeneous expectations, is the maximization of the market value of the firm as expressed by the difference between the expected return and a risk premium that is a function of the covariance between the firm's return and a market portfolio. Stiglitz [60] and Jensen and Long [33] have demonstrated that the investment allocation determined by maximizing this market value is not a constrained Pareto optimum, and Leland [37] and Ekern and Wilson [17] have shown that the value-maximizing allocation is not in the best interests of final shareholders.

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