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

Markowitz (1952) asset risk has long been challenged. First, asset risk has to be cumulative, because asset holder’s risk approaches zero as time length approaches zero (Nie, 2022a). Second, volatility does not decrease asset value while volatility of a lognormal distribution actually raises asset value. Third, support to Markowitz asset risk appears to arise from a confusion between asset value and wealth utility—the law of diminishing marginal utility supports that volatility reduces the latter. To address the challenges, we argue that asset risk causes volatility, but not vice versa, implying that volatility improperly represents asset risk, which cannot be diversified away. We delineate expected value (which asset risk impacts without a distribution) and volatility (which does not affect the former while following a quasi-normal distribution we proposed). We show that our firm risk, captured as equity risk premium, solves issues that have long been challenging agency and contracting theories.