RISK AVERSION THEORY OF LIQUIDITY PREFERENCE/THE MEAN-VARIANCE APPROACH TO PORTFOLIO CHOICE This analysis is simply a special case of the standard theory of Portfolio Choice as developed by Markowitz [1952, 1959]. In this case the choice is between an asset with a certain return, say money with zero return and a portfolio of uncertain assets, say bond with an expected yield about which there is some uncertainty. The particular approach adopted here was developed by Tobin [1958], though the foundations were clearly outlined by Hicks as long ago as 1935. Prof. James Tobin in his famous article “Liquidity Preference as Behaviour towards Risk” formulated the risk aversion theory of liquidity preference. This theory removes two major defects of the Keynesian theory of liquidity preference. One, Keynes’ liquidity preference depends on the elasticity of expectations of future interest rates; and two, individuals hold either money or bonds. Tobin has removed both the defects. His theory does not depend on the elasticity of expectations of future interest rates. It proceeds on the assumption that the expected value of capital gain or loss from holding interest bearing assets is zero. Moreover, it explains that an individual’s portfolio has both money and bonds. Tobin starts his portfolio selection model of liquidity preference with the assumption that an individual asset holder has a portfolio of money and bonds. Money neither brings any return nor imposes any risk. But bonds not only yield some income in the form of interest rate but also impose some risk of capital loss or gain. An investor can bear this if he is compensated by an adequate return from bonds. Tobin introduced the concept of risk aversion. The basic idea of risk aversion is that given two assets with same average return, an investor prefers that asset which has less dispersion or standard deviation. The fact of risk aversion is explained by two things: (a) There is always the risk that an asset with an unstable yield would provide a smaller average return, if it has to be sold before maturity. (b) Income being subject to the law of diminishing marginal utility, the gains of utility to the wealth holder during the periods of higher yield would be smaller than the loss of utility during the periods of low yield. According to Tobin, there are three types of investors in the society: (1) the Risk lovers [Gamblers] who put all their wealth into bonds to maximize risk. They accept risks and act as gamblers. (2) The Plungers: they will either put all their wealth into bonds or will keep it in cash. They either go all the way or not at all. (3) The Risk Averters or diversifiers: The majority of the investors belong to this category. They prefer to avoid risk of loss which is associated with holding of bonds. They try to maximize return and minimize risk.

Liquidity Preference theory is very relevant for the risk averters or diversifiers. Diversifiers generally prefer to hold a mixed portfolio of some cash and some bonds. Every investor acts on the basis of his subjective estimate of probability distribution of risk and return. Assuming that all wealth, W, is held either in the form of money, M, or bond, B, i.e.,

It follows that



The actual yield on the portfolio (R) is

Where r is the rate of return at the time the bond was purchased, and g is capital gain. This expression simply states that the return on the portfolio is equal to the return on bonds multiplied by the proportion of bonds held in the portfolio. This analysis can be simplified by assuming Expected gain, expected yield on the portfolio reduces to so that the

The risk attached to the portfolio is measured by the standard deviation of the return on the portfolio. i.e., The standard deviation of the return expected on the portfolio is equal to the standard deviation of the possibility of capital gain or loss, times that proportion of the bonds held in portfolio.

So that

Substituting equation (5) into (3) gives

With , i.e., the standard deviation of the portfolio cannot exceed the standard deviation of bonds. Equity would be achieved when and the portfolio

consisted entirely of bonds. In this case, the expected return on the portfolio is the same as that expected for bonds. If , the portfolio consists of only money.

The above relationship can be expressed diagrammatically. The OAi lines show the possible combinations of interest and risk available at the time - each higher line represents a higher rate of interest. These are a diagrammatic representation of the relationship expressed in equation (6) then ; and when , then . . If ,

The OP line gives the proportion of wealth allocated to bonds and relates this to the riskiness of the portfolio. This illustrates the relationship expressed in then To summarise: ; and when . . If ,

The exact combination of expected risk and return on the portfolio depends on the proportion of wealth held in bonds. From this it follows that both return and risk are maximized when all wealth is held in the form E(R) A3 (r3) of bonds, i.e., . The OAi lines therefore show A2 (r2) the opportunities open to the investor. A1 (r1)
Return Risk




Wealth I β Figure: Investment Possibility and Portfolio Allocation Schedule


An investor’s attitudes to return and R risk may be IC1 summarized by a set of indifference curvesP representing combinations of Risk expected return and O risk between which the individual is indifferent i.e., they have the same B utility. If we assume that the average L investor likes a positive M Risk C return but dislikes risk N Q and that as risk and returns rise, his Figure: Normal Risk Aversion aversion to the latter rises more than his preference for the former, this will generally result in risk aversion. This case is illustrated in figure below: In order to find out the risk averter’s preference between risk and capital return, Tobin uses indifference curves having positive slopes indicating that the risk averter prefers more return for more risk. This is explained above with the help of figure. In figure, risk is measured horizontally and return vertically, OR is the budget line of the investor. The portfolio consists of money [C] and bonds [B]. The indifference curve indicates the risk averter’s demand for higher expected return for additional risk. The risk averter will fix the equilibrium portfolio at the point of tangency [P] between the indifference curve and the budget line OR. The line OQ shows the proportionality between risk and the share of portfolio held in bonds. When a perpendicular is drawn from P onto the line OQ, the point L is generated which determines the division of the portfolio between cash and bond. Thus an investor will keep OM amount of his wealth in the form of bonds and MN in the form of cash. It is to be noted that the lower vertical axis measures the amount of wealth to be invested. As long as there is no change in the interest rate, the equilibrium point P will not be disturbed. But if there is an increase in the interest rate, there will be more demand for bond and less demand for cash. The opposite will be the case if the interest rate is lowered. In the case of an increase in the interest rate, the budget line goes upward and ultimately becomes tangent to a higher IC. This means that returns increase in relation to risk and the
Wealth Return

investor selects a portfolio where the proportion of cash goes down and bond holding goes up. This is shown in the figure below.

R3 R2

IC3 Return IC2 IC1


It is clear from the figure T that, the budget line O Risk increases with the B1 increase in the interest rate. This is shown by the B2 budget line R1 increasing P B3 to R2 and R3. Consequently, returns increase in relation to W C Risk risk with increase in the interest rate, and the budget line touches higher indifference curves. In the figure budget lines R1, R2 and R3 are tangents to IC1, IC2 and IC3 curves at points T1, T2 and T3 respectively. These points when joined together result in optimum portfolio curve OPC which shows that as the tangency points move upward from left to right, both the expected return and risk increase.

These tangency points also show the portfolio selection of the investor which is shown in the lower portion of the figure. When the equilibrium points go up from T1 to T3 bond holding increases from OB1 to OB3 and cash holding decreases from B1W to B3W. Thus when the rate of interest goes up, the demand for money goes down. Superiority of Tobin’s Analysis Tobin’s risk aversion theory of portfolio selection is superior to Keynesian Liquidity Preference Theory of Speculative Demand for money on the following grounds. 1. Tobin takes into account both money and bond holdings by an investor and not simply money or bond as is done by Keynes. Thus Tobin’s analysis is more realistic and broad. 2. Tobin’s theory does not depend on inelasticity of expectations of future interest rates. It proceeds from the assumption that the expected value of capital gain or loss from holding interest bearing assets is always zero. In this respect, Tobin regards his theory as a logically more satisfactory foundation for liquidity preference than the Keynesian theory. 3. Tobin is more realistic than Keynes in not discussing the perfect elasticity of demand for money [the liquidity trap] at very low levels of interest rate. 4. The real importance of the portfolio theory lies in “not what it tells directly about the aggregate economy but rather it represents an interesting approach to the


problem of relating demand for money to the existence of uncertainty an approach that probably has scope for considerable development in the future”.