APPLYING MODERN PORTFOLIO THEORY TO THE ANALYSIS OF TERRORISM. COMPUTING THE SET OF ATTACK METHOD COMBINATIONS FROM WHICH THE RATIONAL TERRORIST GROUP WILL CHOOSE IN ORDER TO MAXIMISE INJURIES AND FATALITIES

Abstract

In this paper, terrorism is analysed using the tools of modern portfolio theory. This approach permits the analysis of the returns that a terrorist group can expect from their activities as well as the risk they face. The analysis sheds new light on the nature of the terrorist group’s (attack method) choice set and the efficiency properties of that set. If terrorist groups are, on average, more risk averse, the economist can expect the terrorist group to exhibit a bias towards bombing and armed attack. In addition, even the riskiest (from the terrorist group’s point of view) combinations of attack methods have maximum expected returns of less than 70 injuries and fatalities per attack per year.

Keywords:

• Terrorism
• Modern portfolio theory
• Mean‐variance analysis
• Efficient choice set

JEL Codes:

• D00
• G11
• H56

ACKNOWLEDGMENTS

The author would like to thank Dr Glenda Adkins and two anonymous referees for suggestions that greatly improved this paper.

Notes

¹ See Anderton and Carter (2005, 2006) for a discussion of the utility maximisation model applied to terrorism.

² And the application of analytical tools developed in finance or financial economics to the analysis of terrorism and terrorist behaviour (see Phillips, 2005). Although of peripheral relevance, this paper also adds to the literature on price and substitution effects (Faria, 2006; Frey and Luechinger, 2003).

⁴ An economic good is something that is desired but which costs something to obtain. In this case, it is usually assumed to be political power and resources or a monetary equivalent.

⁵ Completeness: given situations A and B an individual can always specify if A is preferred to B, B is preferred to A or A and B are equally attractive; Transitivity: if A is preferred to B and B to C, then A is preferred to C; Continuity: if A is preferred to B then a situation suitably close to A is preferred to B.

⁶ Return on Attack Type

⁷ Also see Phillips (2005) and, for different perspective, Faria (2006).

⁸ Assuming that successful (unsuccessful) attacks increase (decrease) the terrorist’s resources and that these resources are ‘reinvested’ in the same successful (unsuccessful) attack methods. See Enders and Sandler (2002).