Studies of Portfolio Behavior

Donald D. Hester and James Tobin, Editors
John Wiley & Sons, Inc., 1967


This monograph is one of three (Monographs 19,20, and 21) that bring together nineteen essays on theoretical and empirical monetary economics written by recent Yale graduate students and staff members of the Cowles Foundation. Seven of these are based on doctoral dissertations approved by the Yale Economics Department, supervised by Cowles Foundation staff members and other members of the Department.

The sixteen authors do not necessarily have common views about monetary theory and policy or about empirical methods and findings. Their contributions do not fit together in any prearranged master research plan; the idea that they would make a coherent collection is a product of afterthought, not forethought. But the essays do have a certain unity, the result of a common intellectual climate which suggested many of the questions to be asked and many of the theoretical and empirical approaches to finding the answers.

The conception of "monetary" economics underlying this collection of essays is a very broad one. Monetary phenomena are not confined to those involving the quantity of currency and demand deposits, and commercial banks are not the only financial intermediary considered to be of monetary interest. There is no sharp dividing line between assets which are "money" and those which are not or between institutions that emit "money" and those that do not. The emphasis is on differences of degree, not differences in kind. To justify this emphasis, it is only necessary to recall the great difficulty which economists who stress the sovereign importance of the "quantity of money" have in drawing the dividing line to define money.

Monetary theory broadly conceived is simply the theory of portfolio management by economic units: households, businesses, financial institutions, and governments. It takes as its subject matter stocks of assets and debts (including money proper) and their values and yields; its accounting framework is the balance sheet. It can be distinguished from branches of economic theory which take the income statement as their accounting framework and flows of income, saving, expenditure, and production as their subject matter.

Of course, separation of the theory of stocks from the theory of flows is artificial and tentative. Economists work toward the synthesis of the two, and many attempts at combining them have been made, with varying degrees of simplification and success. Nevertheless, the artificial distinction seems a useful one, especially for the development of monetary economics. The processes which determine why one balance sheet or portfolio is chosen in preference to another are just beginning to be studied and understood. In studying these processes it helps to keep the links between capital account and income account as simple as possible. At any rate, that is the approach of most of the essays in this collection.

Like other branches of economic theory, monetary theory has both a microeconomic and a macroeconomic side. Monetary microeconomics concerns the balance sheet or portfolio choices of individual units- households, businesses, or financial institutions. The choices are con- strained by the wealth of the unit and by its opportunities to buy and sell assets and to incur or retire debt. Within these constraints, the choices are affected by the objectives, expectations, and uncertainties of the unit. Monetary macroeconomics concerns the general equilibrium of the capital accounts in the economy as a whole, the way in which asset prices and yields adjust to equate the demands to the supplies of the various assets and debts.

Monetary economics is as old as any branch of economics, but until fairly recently it lacked a solid microeconomic foundation. Elsewhere in economic theory this foundation is supplied by some assumption of optimizing behavior, for example, maximization of utility by consumers or of profits by firms. But the usual assumptions of pure economic theory-perfect certainty, perfect markets, no transactions costs or other frictions-provide no rationale for the holding of diversified portfolios and balance sheets (much less for the holding of money and other low- yield assets) or for the existence of financial institutions. Monetary theory was therefore based for the most part on ad hoc generalizations about capital account behavior, based on common sense or empirical observation rather than on any logically developed notion of optimal behavior.

During the last twenty years, economic theory, stimulated in part by the upsurge of interest in management science and operations research, has tackled directly the problem of defining optimal behavior in situations involving market imperfections, transactions costs and other "frictions." and uncertainties about future prospects The tools developed have proved to have some fruitful applications to monetary behavior, For example, the theory of optimal inventory policy gave solid theoretical explanations of the transactions and precautionary demands for cash- phenomena that have long played a central role in traditional monetary economics. [1]

Another theoretical tool with important uses in monetary analysis originated in the general study of decision-making under uncertainty It became possible to give a precise expression to the common-sense observation that distaste for risk leads investors to diversify portfolios and to hold assets with widely differing expected yields simultaneously, In an earlier Cowles Foundation Monograph,[2] Harry Markowitz proposed a way in which the risk and expected yield of a portfolio could be defined and calculated from the subjective probabilities assigned by an investor to the various future prospects of the assets included in the portfolio. [2] He showed further how to compute efficient portfolios; an efficient portfolio is one whose expected return could not be raised by altering its composition without also increasing risk Markowitz's interest was mainly normative; that is, his objective was to show investors how to be rational, However, if it is assumed that investors are in fact behaving rationally, the same approach can be fruitfully applied in positive monetary analysis, An early application of this kind to the famous question of the "speculative" demand for money was made in the article reprinted here as Chapter 1 of Monograph 19.

The seven essays in Monograph 19, Risk Aversion and Portfolio Choice, have both normative implications. as pieces of advice to investors, and positive implications, as descriptions of the economy They are partly theoretical and partly empirical, They concern, on the one hand, the attitudes of investors toward risk and average return and, on the other, the opportunities which the market and the tax laws afford investors for purchasing less risk at the expense of expected return

Monograph 20, Studies of Portfolio Behavior, is institutionally oriented. The six essays draw on the theoretical developments mentioned above and seek to apply them to the particular circumstances and objectives of various kinds of economic units: households, nonfinancial corporations, banks, and life insurance companies. It is our hope that the analytical tools contribute to the interpretation of the statistical data available on balance sheets and capital accounts.

The subjects of Monograph 21, Financial Markets and Economic Activity, are macroeconomic. They concern the conditions of equilibrium in economy-wide financial markets. The microeconomic principles discussed in the first two monographs are assumed to guide the behavior of individual economic units, including financial intermediaries, in demanding and supplying assets and debts in these markets. But the main focus is on the adjustment of interest rates and other yields to create equilibrium in various financial markets simultaneously. From this standpoint, the quantity of money as conventionally defined is not an autonomous variable controlled by governmental authority but an endogenous or "inside" quantity reflecting the economic behavior of banks and other private economic units. Commercial banks are seen to differ from other financial intermediaries less basically in the nature of their liabilities than in the controls over reserves and interest rates to which they are legally subject. Models of financial market equilibrium can be used to analyze a wide variety of questions about the behavior of financial markets. The theoretical studies in Monograph 21 apply this framework to investigate the consequences of various institutions and regulations for the effectiveness of monetary control. In addition some empirical findings on the structure of interest rates by maturity and by risk category are reported.

Some of the essays were, as indicated in footnotes, written under a grant from the National Science Foundation. We are grateful for their continuing support of research in this area at the Cowles Foundation. The staff of the Cowles Foundation-secretaries, librarians, and research assistants-has contributed efficiently and cheerfully to the original preparation of the papers and to their assembly into Monographs 19, 20, and 21. Particular gratitude is due Miss Althea Strauss, whose loyal and indefatigable service as administrative assistant provides important continuity at the Foundation, and to Mrs. Amanda Slowen, on whom fell the exacting task of retyping some of the material. Finally, the editors and all the authors are in greater debt than they may realize to Karen Hester, who painstakingly and skillfully edited the papers for inclusion in the monograph. She improved them both in English and in economics, but she is not responsible for the defects that remain.

New Haven, Connecticut
October, 1966
Donald D. Hester
James Tobin


Chapter 1. Consumer Expenditures and the Capital Account, Harold Watts and James Tobin

Chapter 2. Consumer Debt and Spending: Some Evidence from Analysis of a Survey, James Tobin

Chapter 3. An Empirical Study of Cash, Securities, and Other Current Accounts of Large Corporations, Alan W. Heston

Chapter 4. An Empirical Examination of a Commercial Bank Loan Offer Function, Donald D. Hester

Chapter 5. An Empirical Model of Commercial Bank Portfolio Management, James L. Pierce

Chapter 6. Life Insurance Investment: The Experience of Four Companies, Leroy S. Wehrle


[1] See William J Baumol, "The Transactions Demand for Cash: An Inventory Theoretic, Approach," Quarterly Journal of Economics, Vol. LXVI, No. 4 (November 1952), pp.545-56; James Tobin, "The Interest-Elasticity of Transactions Demand for Cash," The Review of Economics and Statistics, Vol. XXXVIII, No. 3 (August 1956), pp. 241-8; and Don Patinkin, Money, Interest and Prices (Evanston: Row, Peterson and Company, 1956), Chap.7.

[2] Harry M. Markowitz, Portfolio Selections: Efficient Diversification of Investments (New York: John Wiley and Sons, 1959).