Address Challenges Markowitz (1952) Faces: A New Measure of Asset Risk

Markowitz (1952) asset risk (MAR) has long been challenged. First, asset volatility captures the noise of asset risk over maturity that improperly reflects asset risk (which has to be measured over a unit of time length to be cumulative since asset holder’s risk approaches zero as the holding time length approaches zero). Second, we argue that a payment’s risk approaches zero as distance approaches zero, and that asset risk drives volatility, but not vice versa, implying that asset risk cannot be diversified away. Third, support to MAR appears to arise from a confusion between asset value and wealth utility—the law of diminishing marginal utility supports that volatility reduces the latter rather than the former. These causes explain why CAPM and Fama-French models have long been struggling to price asset volatilities. To address the challenges, we delineate expected asset value (which asset risk impacts without a distribution) and risk volatility (which does not affect the former while following a blended normal distribution we proposed). Our asset risk for a specific asset excludes the macrorisk or inflation risk in Nie (2024a) that is tied to assets with a face value denominated by the depreciating currency. We propose that the gross volatility (variance), which includes the excess risk ALPHA, of realized(expected) asset value approaches zero as distance approaches zero. We show that equity price reflects the present value of a spanning bond—a payment spanning over the predictable lifetime of firm performance, and that options are actually equity bonds. Arguing that volatility reflects the noise of equity risk over maturity, we calibrate equity risk as a one-year payment’s risk that accounts for equity maturity. Thus our asset risk, captured as risk premium, solves issues that have long been challenging agency theories, thereby redefining firm misvaluation theory and agency theory.