Tobin’s Portfolio Diversification Model

Tobin’s Portfolio Diversification Model

Tobin developed a model to explain portfolio diversification that
did not require individuals to have an idea of a ‘normal’ interest
rate.

Basic idea:
This model is based on the idea that people are risk averse and
therefore choose to diversify their assets

Assumptions:
There is no ‘normal’ interest rate in Tobin’s model;
The returns on bonds = r + G.
Capital gains on bonds (G) can be positive or negative
The individual believes that gains and losses are equally
likely so that the expected capital gain is zero. Therefore the
best expectation of the total return on bonds is just the
interest rate, r. Bonds it must be noted are risky assets as
there is a possibility of capital loss when bond prices fall.

Money, on the other hand, is a safe asset by has zero
returns.

There is therefore a trade-off between bonds and money. By
holding more bonds, a person will enjoy higher returns but there
is also the risk of holding one’s wealth in bonds. Hence, a risk
averse person is willing to give up some of this possible return for
the security of holding some money.