Risk Management: Modern Portfolio & Behavioral Finance Theory
Many investment strategies are based on a model for financial markets called Modern Portfolio theory. The idea is that market participants are rational actors who operate within a particular framework. The last few decades have seen a new theory emerge, one built on behavioral finance. Let us look at each!
Modern Portfolio Theory (MPT)
Modern Portfolio Theory, also called mean-variance analysis, is a widely used model for structuring your investment portfolio. MPT was developed by Nobel Prize Laureate Harry Markowitz. The theory behind MPT is that investors should spread out investment portfolio risk by diversifying their holdings into safer, more stable investments with lower returns, along with riskier investments that may reap bigger rewards.(1)
MPT examines historical data to determine which investments are considered the riskiest as well as how those investment assets move with one another. The hope is to get the greatest return for each “unit” of volatility the investor is willing to accept.MPT makes a few upfront assumptions. The first is that the financial markets themselves are efficient. Efficiency is all fast or well new information is reflected in the price. MPT also believes that investors are largely rational, with the capability of choosing an optimal portfolio based on their view of the inputs. Additionally, MPT assumes that investors are largely risk-averse and would rather have more stable investments with a greater likelihood of a return, even if those returns are smaller than riskier investments.
A few MPT tenets might not appear stable if examined closely. For instance, assuming that financial markets are efficient, cycles of volatility should not exist. Periods of large losses are clustered around large gains. Getting engrossed in the rush and excitement of a bull market or a hot asset class is easy, causing many to chase after what looks like a “sure thing.” Investing using the MPT method involves examining historical data that may overlook recent market changes, potentially impacting a certain asset class or investment. This is important as many of the variables change over time.
Behavioral Finance Theory
Whereas MPT assumes that the stock market and investors are rational, behavioral finance theory examines investing through a more human lens. Behavioral economics was developed in the 1970s and is based on sociologists’ and psychologists’ assertions that humans exercise less than rational decision-making. This investing framework explores people’s actions and how they are most likely to respond in given scenarios.
Behavioral finance theory accepts that people are unable to separate their decisions from their emotional thoughts and biases. This explains why someone might hold onto a losing asset, especially if a strong emotional feeling exists. For example, if you were gifted a stock as part of an inheritance, releasing the stock may be difficult despite its poor performance. The desire to belong and “follow the herd” is another reason that investors might feel the pain of loss from not engaging in a bull market or a certain hot investment. Behavioral finance theory also sees markets as irrational and prone to investors’ whims. If you have lived through one—or several—market bubbles and busts, this idea does not seem too far-fetched. In fact, many times when we mention that MPT is based on rational market participants, friends and clients often chuckle themselves as they realize their experience has been different.
While behavioral finance theory can tell you a lot about yourself and your personal investing strategy, it cannot predict the markets. Although the theory may predict how you will handle the rollercoaster ride of investing, its helpfulness as a solid investment strategy remains uncertain.
How are your investments managed?
No investment strategy is perfect. The key is finding what resonates with you. Chances are you do not know the philosophy of your investment professional. You should speak with your financial advisor to ensure that you understand each other’s investment strategies, challenge your own cognitive biases, and become a more rational investor. Answering a few questions on how you operate may offer some insight into what type of investor you are and the best methods to suit your personality. A recommended reading is the Laws of Wealth by Dr. Daniel Crosby. Here he explains common investment biases and sometimes how to help you overcome them and even take advantage of misbehavior that may come from other investors.
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