CHAPTER 9

The Leverage

Space Model

S

ince the 1950s, when formal portfolio construction was put forth, peo-
ple have sought to discern optimal portfolios as a function of two com-
peting entities, risk and return. The objective was to maximize return
and minimize risk. This is the old paradigm. It’s how we have been taught to
think.
Quoting from Kuhn,^1 “Acquisition of a paradigm and of the more eso-
teric type of research it permits is a sign of maturity in the development of
any given scientific field.”
This is precisely what happened. Portfolio construction, after the sec-
ond world war, acquired a mathematical rigor that had been missing prior
thereto. Earlier, it was, as in so many other fields, the fact-gathering phase
where each bit of data seemed equally relevant. However, with the paradigm
presented as the so-calledModern Portfolio Theory(a.k.a.E-V Theory or
mean-variance model), the more esoteric type of research emerged.
Particularly troubling with this earlier paradigm was the fact that the
unwanted entity, risk, was never adequately defined. Initially, it was argued
that risk was the variance in returns. Later, as the arguments that the vari-
ance in returns may be infinite or undefined, and that the dispersion in
returns wasn’t really risk, calamitous loss was risk, the definitions of risk
became ever more muddled.
Overcoming ignorance often requires a new and different way of looking
at things.

(^1) Thomas S. Kuhn,The Structure of Scientific Reduction, The University of Chicago
Press, 1962.
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