We have questioned many orthodoxies of modern portfolio theory (MPT) in this series, challenging currently accepted models of financial markets and exploring the decline of MPT and the folly of using volatility as a measure of investment risk.
But in undermining the foundations of MPT, what do we propose to take its place?
It is time to move away from MPT to a more promising alternative: behavioral finance. The analytical tools derived from behavioral finance’s more realistic representation of financial markets and human behavior will likely replace the wealth-limiting MPT tools in use today. Sadly, these same outdated and ineffective MPT tools help select and evaluate active equity managers. Abandoning such obsolete instruments is critical to ushering in the active equity renaissance.
A fully developed behavioral model of financial markets does not yet exist, but several underlying concepts and their resultant implications for investment management are emerging.
A Prospective Investment Framework
Financial markets are populated by human investors burdened with emotional baggage and associated cognitive errors. In a market context, these errors are amplified because, in the aggregate, they create herding, which leads to wild price swings. Rampaging emotional crowds cause extreme volatility of returns in financial markets. Look no further than equity market price bubbles for evidence of these rampaging emotions.
Behavioral Concept 1: Emotional crowds, not fundamental changes, drive price movements in financial markets.
Financial markets cannot be neatly packed into a set of mathematical equations. Markets are messy, and the only way to make sense of them is to view them in all their disorder.
We will never understand why markets and their underlying securities move the way they do over shorter time periods. So if we’re asked why the market, a stock or other security moved the way it did on a particular day, the honest answer is almost always, “I have no idea.” In fact, research demonstrates that only a minute percentage of the market transacts on any given day. Yet investors and investment journalists always ascribe a rationale to market movements even when the implied causality is chimerical. Unsettling as this may be, it is an effect of our first behavioral concept: Emotions — not fundamentals — are the main movers of financial markets.
Behavioral Concept 2: Investors are not rational, and financial markets are not informationally efficient.
This concept runs directly counter to some of the major conceits of 20th-century finance theory: that investors are expected utility maximizers and market prices reflect all relevant information.
Behavioral economics research decimates the expected utility model. It is virtually impossible for an individual to collect all needed information and then accurately process that information to come up with a rational decision. This is known as bounded rationality, first introduced by economist Herbert Simon.
Even more damaging, Daniel Kahneman, Amos Tversky and others convincingly demonstrated that even when all information is available, individuals are highly susceptible to cognitive errors. As Kahneman and Tversky concluded after years of research, human beings are typically not rational decision makers.
The very concept of utility is flawed. If utility seeks to inject a happiness measure into economic theory, then what aspect of happiness is it gauging: expected, realized or remembered? Research finds these three to be quite different, even when the same person experiences each. Happiness and, in turn, utility are hopelessly malleable concepts.
Since we are strongly predisposed to make cognitive mistakes due to our emotions, it takes only a small step to conclude that markets cannot be informationally efficient. The evidence supporting this conclusion is vast: There are hundreds of statistically verified anomalies in the academic literature and more continue to be found.
Implications for Investment Management
A bleak picture of markets emerges: Emotional investors, with their cognitive biases and instinct toward herding, constantly drive prices away from the underlying fundamental value. Unexpectedly, analyzing markets through a behavioral lens provides a more reliable framework. Why? Because individuals rarely change their behaviors, and investing crowds are even less inclined to alter their collective behavior.