Subjectivity and Information Efficiency: The Unification and Validation of Portfolio Theory and Practice

Publisher: Working paper

Abstract:

To date, no evidence in the literature suggests there exists a comprehensive portfolio theory capable of coherently explaining a range of prevailing investor portfolio-decision behaviours throughout, such as, equal weighting, factor ranking, ratio weighting, portfolio concentration etc., let alone guiding practices. This paper proves portfolio theory and practices can be precisely explained and unified under a new information and Pareto double-efficiency allocation model and unearths that portfolio decisions are fundamentally view-driven. To derive and validate this model, we also introduce a new portfolio subjective information efficiency concept and testing criterion based on information entropy, and a novel theory-validation methodology against observed behaviours. From the insight derived, this paper envisages a paradigm shift from modelling portfolio selection as a one-shot optimisation to a more natural, cognitive process.

Source: Manual