Wednesday, January 20, 2016

Modern Portfolio Theory vs. Behavioral Finance

Final Semester Begins for the Students in the AIM Program

Traditional finance assumes that we are rational, while behavioral finance simply assumes we are normal. —Meir Statman

The spring (and final) semester for the students in the AIM program at Marquette University begins with the clash of competing concepts: modern portfolio theory and behavioral finance.

Modern portfolio theory (also known as MPT) and behavioral finance represent two quite different schools of economic thought that attempt to explain investors’ behaviors. Maybe the best way to think about their arguments and positions is to consider modern portfolio theory as how the financial markets would work in the ideal or perfect world - and behavioral finance as how the financial markets work in the real world. The students will gain a solid understanding of both concepts which will help them make better long-term investment decisions.

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Modern Portfolio Theory is the basis for almost all of the conventional thought that underpins investment decision making. There are many core points of MPT that were developed in the early 1960s by the efficient market hypothesis (EMH) that was postulated by Dr. Eugene Fama from the University of Chicago. According to Fama’s EMH theory, financial markets are highly efficient, all investors make rational decisions, market participants are informed and act rationally on all available information. If everyone has the same access to the relevant information, then under MPT all securities will be appropriately priced at any given time. Therefore if markets are efficient, it means that security prices always reflect all information – so prices will be fairly priced.

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Other pieces of conventional MPT thought include the notion that the stock market will return an average of about 5% per year above the risk-free rate of return – historically this would be about 10% annual return over the past century. While the theory is solid, the empirical results have indicated it is not perfect and a number of unexplained anomalies exist.

Hence the emergence of Behavioral Finance. Despite the classical, rational  theories under MPT, stocks often trade at unjustified prices, investors make irrational decisions, and it is difficult to find anyone (including large institutional investors) who own the market portfolio. Instead, many financial economists have recently acknowledged that emotion and psychology play a larger role in investor decision-making, sometimes causing investors to behave in unpredictable or irrational ways.
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The AIM students will learn that the best way to consider the differences between theoretical and behavioral finance is to view MPT as a framework from which to develop an understanding of the how markets would operate with perfect information and rational decision-makers – and to view behavioral finance as representative of the notion that theories do not always hold water in the real world. Therefore, we believe that providing our students with a solid background in both perspectives will help them make better investment decisions professionally and as individual investors. 

We’ll compare and contrast the major topics – and then report how the students feel about the modern portfolio theory and behavioral finance.

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