Ran Duchin

Markowitz Versus the Talmudic Portfolio Diversification Strategies

Although expected utility theory and the classical mean variance diversification theory of Markowitz assert that optimal diversification depends on the joint distribution of returns, investors tend to ignore these well-accepted theoretical approaches in favor of the naïve investment strategy promulgated in the Babylonian Talmud called the 1/3 rule (or the 1/n rule for n assets),which assigns an equal weight to each security in the portfolio. In testing the efficiency of the 1/n rule, the authors find that it outperforms the mean variance rule for individual small portfolios out of sample, but for large portfolios (i.e., institutional investors) the Markowitz strategy is superior. The advantage of the 1/n rule in the out-of-sample analysis is the absence of exposures to estimation errors.

Looking in the Rearview Mirror: The Effect of Managers' Professional Experience on Corporate Financial Policy

Firms hold unprecedentedly high levels of cash with aggregate balances reaching

Peer Effects in Risk Aversion and Trust

1.5 trillion in 2011. Roughly 80% of this cash is concentrated in a small number of large, mature firms with high earnings, low volatility, few investment opportunities and high credit ratings that slowly adjust cash toward a target. These attributes are inconsistent with the precautionary savings motive. We find that managers’ conservatism explains the cash holdings of the cash-richest firms. Conservative managers hold higher cash balances, save more cash out of cash flow and security issuance, and the value of their firms’ cash holdings is substantially lower.

Precautionary Savings with Risky Assets: When Cash Is Not Cash

Existing evidence shows that risk aversion and trust are largely determined by environmental factors. We test whether one such factor is peer influence. Using random assignment of MBA students to peer groups and predetermined survey responses of economic attitudes, we find causal evidence of positive peer effects in risk aversion and no effects in trust. After the first year of the MBA program, the difference between an individual and her peers’ average risk aversion has shrunk by 41%. Finding no peer effects in trust is consistent with recent research showing that distinct cognitive processes govern risk aversion and trust. (JEL D81, D83, D01)

Disagreement, Portfolio Optimization, and Excess Volatility

We show that U.S. industrial firms invest heavily in non-cash, risky financial assets such as corporate debt, equity, and mortgage-backed securities. Risky assets represent 40% of firms’ financial portfolios, or 6% of total book assets. We present a formal model to assess the optimality of risky financial investments. Consistent with the model’s predictions, risky assets are concentrated in financially unconstrained firms that hold large financial portfolios. Further, they are undertaken by poorly governed firms and discounted by 13-22% compared to safe assets. We conclude that this activity represents an unregulated asset management industry of more than

Markowitz’s Mean–Variance Rule and the Talmudic Diversification Recommendation

1.5 trillion, questioning the traditional boundaries of nonfinancial firms.

Political Influence and Government Investment: Evidence from Contract-Level Data

Disagreement, a key factor inducing trading, has been receiving ever increasing attention in recent years. Most research has focused on disagreement about the expected returns. Several authors have shown that if the average belief coincides with the true expected return, in the portfolio context prices are unaffected by disagreement. In this paper we study the pricing effects of disagreement about return variances. We show that i) disagreement about variances has systematic and significant pricing effects—more disagreement leads to higher prices, and ii) prices are very sensitive to the degree of disagreement: Even if the average belief about the variance is constant, tiny fluctuations in the disagreement about the variance lead to substantial price fluctuations. This second result may offer an explanation for the excess volatility puzzle: When small changes in the degree of disagreement occur, they induce relatively large price changes. Yet, the changes in disagreement may be hard to directly detect empirically, leading to apparent “excess volatility.”

Comments on: 'The Trouble with Instruments: Re-Examining Shock-Based IV Designs' by Atanasov and Black

Markowitz’s breakthrough Mean–Variance theoretical article is the foundation of the CAPM and many other models in economics and finance. But the Mean–Variance rule is also widespread in practice, and this is the focus of this paper. While expected utility theory and Markowitz’s classical diversification theory assert that the optimal diversification depends on the joint distribution of returns, experiments reveal that subjects tend to ignore the joint distribution and adopt the naive investment strategy called the “1 ∕ N rule,” which assigns an equal weight to each security the subjects face. We test the efficiency of the “1 ∕ N rule” and find that in in-sample, its employment induces a substantial expected utility loss. However, the out-of-sample case, which is the relevant framework for investors, reveals a relatively small loss and in many cases a gain. The advantage of the “1 ∕ N rule” in the out-of-sample analysis is that it is not exposed to estimation errors.

Costly External Finance, Corporate Investment, and the Subprime Mortgage Credit Crisis

We use contract-level data to study the effect of corporate political influence on the allocation, design, and real outcomes of government contracts. To isolate the treatment effect of political influence, we focus on campaign contributions in close elections and the 2009 American Recovery and Reinvestment Act. Firms with political influence win more contracts, with larger amounts, weaker competition, and looser oversight, and successfully renegotiate contract terms. While preferred access to government contracts improves performance and output, contractual laxity exacerbates agency problems and erodes efficiency. Overall, we provide estimates of the dual effect of political influence on firm outcomes.We use contract-level data to study the effect of corporate political influence on the allocation, design, and real outcomes of government contracts. To isolate the treatment effect of political influence, we focus on campaign contributions in close elections and the 2009 American Recovery and Reinvestment Act. Firms with political influence win more contracts, with larger amounts, weaker competition, and looser oversight, and successfully renegotiate contract terms. While preferred access to government contracts improves performance and output, contractual laxity exacerbates agency problems and erodes efficiency. Overall, we provide estimates of the dual effect of political influence on firm outcomes.

When Are Outside Directors Effective

Atanasov and Black (2015) (AB) analyzes potential limitations of empirical studies that use shock-based IV designs, focusing specifically on our article that studies the effect of board independence on firm value (Duchin et al., 2010). With regard to our study, AB raises three concerns with our analysis. This note presents our reaction to AB’s analysis. We agree with two of the concerns in the abstract; it turns out they do not matter for the substance of our analysis. We disagree on the critical issue concerning selection of covariates. As a guide to future research, we highlight the nature of the disagreement, and explain why we believe covariates should be motivated by theory, and why an a theoretical approach to selecting covariates can result in failure to identify effects that actually exist. An important lesson from the analysis is that researchers should exercise caution when including ad-hoc covariates in empirical specifications. We offer concluding thoughts about empirical research and causal inference.