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Portfolio insurance, portfolio theory, market simulation, and risks of portfolio leverage

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  • Bruce I. Jacobs

    (Jacobs Levy Equity Management)

  • Kenneth N. Levy

    (Jacobs Levy Equity Management)

Abstract

Bruce Jacobs, Ken Levy, and Harry Markowitz shared similar interests and did comple- mentary work. This led to collaboration, debate, and building upon each other’s ideas and research. They had a prodigious relationship of over 30 years, bridging the gap between theory and practice. Bruce individually, and then with Harry, distinguished between portfolio insurance and portfolio theory. Bruce and Ken estimated security expected returns using cross-sectional analysis, and Harry used that methodology for portfolio management. Bruce and Ken used Harry’s methods for portfolio construction, and they jointly explored the value of using constraints in portfolio optimization and addressed the optimality and optimization of long–short portfolios. Bruce, Ken, and Harry jointly developed an asynchronous, discrete-time, dynamic market simulator, JLMSim, to explain the behavior of security prices and to find equilibrium expected returns. Bruce and Ken extended portfolio theory to account for the unique risks of leverage and applied investor volatility aversion and leverage aversion to portfolio choice. The optimal portfolio lies within an efficient region and on a three-dimensional efficient surface. Harry concurred that the mean–variance model is a special case of the mean–variance–leverage model. Bruce and Ken used the mean–variance–leverage model to address the optimal amount of leverage in 130–30-type portfolio strategies. Bruce and Ken would challenge Harry, and Harry would challenge Bruce and Ken, and out of that would often come something interesting and useful.

Suggested Citation

  • Bruce I. Jacobs & Kenneth N. Levy, 2025. "Portfolio insurance, portfolio theory, market simulation, and risks of portfolio leverage," Annals of Operations Research, Springer, vol. 346(1), pages 67-97, March.
    • Handle: RePEc:spr:annopr:v:346:y:2025:i:1:d:10.1007_s10479-024-06248-2
    DOI: 10.1007/s10479-024-06248-2
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    References listed on IDEAS

    as
    1. M. Bloch & J. Guerard & H. Markowitz & P. Todd & G. Xu, 2020. "A comparison of some aspects of the U.S. and Japanese equity markets," World Scientific Book Chapters, in: John B Guerard & William T Ziemba (ed.), HANDBOOK OF APPLIED INVESTMENT RESEARCH, chapter 3, pages 17-40, World Scientific Publishing Co. Pte. Ltd..
    2. Jacobs, Bruce & Levy, Kenneth, 2014. "The unique risks of portfolio leverage: why modern portfolio theory fails and how to fix it," Journal of Financial Perspectives, EY Global FS Institute, vol. 2(3), pages 113-126.
    3. Elton, Edwin J & Gruber, Martin J & Padberg, Manfred W, 1978. "Simple Criteria for Optimal Portfolio Selection: Tracing out the Efficient Frontier," Journal of Finance, American Finance Association, vol. 33(1), pages 296-302, March.
    4. Stephen Boyd & Kasper Johansson & Ronald Kahn & Philipp Schiele & Thomas Schmelzer, 2024. "Markowitz Portfolio Construction at Seventy," Papers 2401.05080, arXiv.org.
    5. Chanaka Edirisinghe & Jingnan Chen & Jaehwan Jeong, 2023. "Optimal Leveraged Portfolio Selection Under Quasi-Elastic Market Impact," Operations Research, INFORMS, vol. 71(5), pages 1558-1576, September.
    6. Bruce I. Jacobs, 2009. "Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis," Financial Analysts Journal, Taylor & Francis Journals, vol. 65(2), pages 17-30, March.
    7. Kalman J. Cohen & Jerry A. Pogue, 1967. "An Empirical Evaluation of Alternative Portfolio-Selection Models," The Journal of Business, University of Chicago Press, vol. 40, pages 166-166.
    8. William F. Sharpe, 1963. "A Simplified Model for Portfolio Analysis," Management Science, INFORMS, vol. 9(2), pages 277-293, January.
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    10. Bruce I. Jacobs, 2004. "Risk Avoidance and Market Fragility," Financial Analysts Journal, Taylor & Francis Journals, vol. 60(1), pages 26-30, January.
    11. Bruce I. Jacobs & Kenneth N. Levy & Harry M. Markowitz, 2005. "Portfolio Optimization with Factors, Scenarios, and Realistic Short Positions," Operations Research, INFORMS, vol. 53(4), pages 586-599, August.
    12. J. Tobin, 1958. "Liquidity Preference as Behavior Towards Risk," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 25(2), pages 65-86.
    13. Harry Markowitz, 1956. "The optimization of a quadratic function subject to linear constraints," Naval Research Logistics Quarterly, John Wiley & Sons, vol. 3(1‐2), pages 111-133, March.
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    16. Treynor, Jack L & Black, Fischer, 1973. "How to Use Security Analysis to Improve Portfolio Selection," The Journal of Business, University of Chicago Press, vol. 46(1), pages 66-86, January.
    17. Bruce I. Jacobs & Kenneth N. Levy & Harry M. Markowitz, 2010. "Simulating Security Markets in Dynamic and Equilibrium Modes," Financial Analysts Journal, Taylor & Francis Journals, vol. 66(5), pages 42-53, September.
    18. Pogue, G A, 1970. "An Extension of the Markowitz Portfolio Selection Model to Include Variable Transactions' Costs, Short Sales, Leverage Policies and Taxes," Journal of Finance, American Finance Association, vol. 25(5), pages 1005-1027, December.
    19. Kroll, Yoram & Levy, Haim & Markowitz, Harry M, 1984. "Mean-Variance versus Direct Utility Maximization," Journal of Finance, American Finance Association, vol. 39(1), pages 47-61, March.
    20. Bruce I. Jacobs & Kenneth N. Levy, 2012. "Leverage Aversion and Portfolio Optimality," Financial Analysts Journal, Taylor & Francis Journals, vol. 68(5), pages 89-94, September.
    21. Levy, H & Markowtiz, H M, 1979. "Approximating Expected Utility by a Function of Mean and Variance," American Economic Review, American Economic Association, vol. 69(3), pages 308-317, June.
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