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

Markowitz (1952) asset risk (MAR) has long been challenged. First, as an impostor of asset risk, volatility captures the noise of firm risk over asset maturity that incorrectly 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, volatility does not decrease asset value while volatility of a lognormal distribution actually raises the value. We thus argue 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. The above causes explain why CAPM and Fama-French models have long been struggling to price asset volatilities. To address these challenges, we propose that the volatility (variance) of realized (expected) asset value approaches zero as the measuring distance approaches zero. We delineate expected asset value (which asset risk impacts without a distribution) and volatility (which does not affect the former following a quasi-normal distribution we proposed). As debt risk of Nie (2024a), our equity risk is rooted in a payment’s risk that approaches zero as the distance approaches zero, reflecting a 5-year payment’s risk to be comparable across assets and across firms. We show that equity price reflects the present value of a payment spanning over the predictable lifetime of firm performance, and that an option’s price minus its present value reflects the overcharge or transaction cost. Our asset risk, captured as risk premium, thus solves issues that have long been challenging agency theories, and redefines firm misvaluation theories.