The Gap between the Subjective Rate of Time Preference and the Market Rate of Return: A Confirmation Based on a Linear Program of Portfolio Choices Utilizing Primary Data

Eduardo  B. Buhain,

The Gap between the Subjective Rate of Time Preference and the Market Rate of Return: A Confirmation Based on a Linear Program of Portfolio Choices Utilizing Primary Data

Abstract:

The feasibility or soundness of building a model that will capture optimal portfolio choices for various individual types and groups have been pioneered by Markowitz in the early 1950s. His portfolio theory begins by assuming that individuals have on hand surplus funds which are invested for a certain period of time. The upcoming proceeds borns out of the holding period are either used in consumption or reinvestment activities. In the pursuit of return maximization, the rationality of diversification ensues. The process of diversifying the said asset holdings produces two results, one, being the increase in the stock of wealth; and the other, its gradual reduction. Under the assumption that the homo oeconomicus is rationale, degradation of current wealth stock resulting from a diversified portfolio becomes a disutility, thereby causing the economic man to shun the investment game and focus attention on short-term horizons, resulting to subjective rates of time preferences geared towards the present period under the guise of consurnption activities. This risk averse behavior alters the portfolio mix, with a bias for investment instruments with shorter gestation periods (such as treasury bills, Central Bank bills, certificates of time deposits, and the like) On the other hand, bullish sentiments with the increase in the stock of wealth in mind, coupled with a risk neutral attitude and sound market rates of return (which lie above the economic man's subjective rate) induces reinvestment activities towards instruments with longer gestation periods (such as stocks and bonds).

With the above concept in mind, this paper addresses the growing perception that the reason behind the choice of a short term portfolio mix, in place of long term may be rationalized by the wide difference between the individual investor's subjective rate of time preference and the market rate of return. The role then of searching for the mix-optima through the linear programming algorithm becomes a tool to validate the existence of such a gap in the two rates, and view the investors' subjective time preferences.