Portfolio Modelling and the Characteristics Approach

The developments in modern portfolio theory have had a significant impact on the literature in the area of investment management and whilst many investment analysts have still to be convinced of the merits of the beta of a stock, the principles of diversification within a portfolio of ordinary shares are generally accepted. Investors, however, whether institutional or as individuals, generally hold diversified portfolios across a variety of asset classes. Although the literature here becomes a lot thinner, there are broadly two main approaches. There is what we can refer to as the “traditional” approach which develops a single period model of the Tobin‐Markovitz type. The hallmark of these is the analytical rigour they pursue with a range of simplifying assumptions and the bulk of work on banks and more recently life insurance companies has been based on this approach. The alternative approaches which permit the inclusion of institutional facets of behaviour that appear to determine their behaviour are referred to as ‘ad hoc’ models because they utilise various aspects of the ‘traditional’ portfolio model, including “stock” as well as pure “flow of funds” models. Work on life insurance companies and building societies has been performed utilising such approaches.