Modern Portfolio Theory vs. Behavioral Finance

By Lisa Smith AAA

Modern portfolio theory and behavioral finance represent differing schools of thought that attempt to explain investor behavior. Perhaps the easiest way to think about their arguments and positions is to think of modern portfolio theory as how the financial markets would work in the ideal world, and behavioral finance as how financial markets work in the real world. Having a solid understanding of both theory and reality can help you make better investment decisions.

Modern Portfolio Theory
Modern portfolio theory is the basis for much of the conventional wisdom that underpins investment decision making. Many core points of modern portfolio theory were captured in the early 1960s by the efficient market hypothesis put forth by Eugene Fama from the University of Chicago. According to Fama’s theory, financial markets are efficient, investors make rational decisions, market participants are sophisticated, informed and act only on available information. Since everyone has the same access to that information, all securities are appropriately priced at any given time. If markets are efficient and current, it means that prices always reflect all information, so there's no way you'll ever be able to buy a stock at a bargain price.

Other snippets of conventional wisdom include the theory that the stock market will return an average of 8% per year (which will result in the value of an investment portfolio doubling every nine years), and that the ultimate goal of investing is to beat a static benchmark index. In theory, it all sounds good. The reality can be a bit different.

Enter Behavioral Finance
Despite the nice, neat theories, stocks often trade at unjustified prices, investors make irrational decisions, and you would be hard pressed to find anyone who owns the much-touted “average” portfolio generating an 8% return every year like clockwork. So, what does all of this mean to you? It means that emotion and psychology play a role when investors make decisions, sometimes causing them to behave in unpredictable or irrational ways. This is not to say that theories have no value, as their concepts do work - sometimes.

Perhaps the best way to consider the differences between theoretical and behavioral finance is to view the theory as a framework from which to develop an understanding of the topics at hand, and to view the behavioral aspects as a reminder that theories don’t always work out as expected. Accordingly, having a good background in both perspectives can help you make better investment decisions. Comparing and contrasting some of the major topics will help set the stage.

Market Efficiency
The idea that financial markets are efficient is one of the core tenets of modern portfolio theory. This concept, championed in the efficient market hypothesis, suggests that at any given time prices fully reflect all available information on a particular stock and/or market. Since all market participants are privy to the same information, no one will have an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else. In efficient markets prices become unpredictable, so no investment pattern can be discerned, completely negating any planned approach to investing. On the other hand, studies in behavioral finance, which look into the effects of investor psychology on stock prices, reveal some predictable patterns in the stock market.

Knowledge Distribution
In theory, all information is distributed equally. In reality, if this was true, insider trading would never take place. Surprise bankruptcies would never happen. The Sarbanes-Oxley Act of 2002, which was designed to move the markets to greater levels of efficiency because the access to information for certain parties was not being fairly disseminated, would not have been necessary. And let’s not forget that personal preference and personal ability also play roles. If you choose not to engage in the type of research conducted by Wall Street stock analysts, perhaps because you have a job or a family life and don’t have the time or the skills, your knowledge will certainly be surpassed by others in the marketplace who are paid to spend all day researching securities. Clearly, there is a disconnect between theory and reality.

Rational Investment Decisions
Theoretically, all investors make rational investment decisions. Of course, if everyone was rational there would be no speculation, no bubbles and no irrational exuberance. Similarly, nobody would buy securities when the price was high and then panic and sell when the price drops. Theory aside, we all know that speculation takes place and that bubbles develop and pop. Furthermore, decades of research from organizations such as Dalbar, with its Quantitative Analysis of Investor Behavior study, show that irrational behavior plays a big role and costs investors dearly.

Bottom Line
While it is important to study the theories of efficiency and review the empirical studies that lend credibility to them, in reality markets are full of inefficiencies. One reason for the inefficiencies is that every investor has a unique investment style and way of evaluating an investment. One may use technical strategies while others rely on fundamentals, and still others may resort to using a dartboard. Many other factors influence the price of investments, ranging from emotional attachment, rumors and the price of the security to good old supply and demand. Clearly, not all market participants are sophisticated, informed and act only on available information. But understanding what the experts expect - and how other market participants may act - will help you make good investment decisions for your portfolio and prepare you for the market’s reaction when others make their decisions.

Knowing that markets will fall for unexpected reasons and rise suddenly in response to unusual activity can prepare you to ride out the volatility without making trades you will later regret. Understanding that stock prices can move with “the herd” as investor buying behavior pushes prices to unattainable levels can stop you from  buying those overpriced technology shares. Similarly, you can avoid dumping an oversold but still valuable stock when investors rush for the exits.

Education can be put to work on behalf of your portfolio in a logical way, yet with your eyes wide open to the degree of illogical factors that influence not only investors' actions, but security prices as well. By paying attention, learning the theories, understanding the realities and applying the lessons, you can make the most of the bodies of knowledge that surround both traditional financial theory and behavioral finance.

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