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.
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.
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.
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.
