There are two different belief systems that serve as the basis for investment decisions: the modern portfolio theory (MPT) and behavioral finance (BF). A basic summary of the two schools of thought: the MPT focuses on the optimal state of the market, while BF is more focused on the actual state of the market. With an understanding of these two methods of thinking, you can gain a better understanding of the market, as well as your individual role as an investor.
Modern Portfolio Theory: Assuming the Best
If you’re interested in learning more about the MPT, a good reference point is Eugene Fama’s Efficient Market Hypothesis, published in the 1960s. Fama, known as the father of modern finance,3 takes an idealist approach to investments. In his theory, Fama describes a world in which the markets are efficient, where those who invest always make smart, forward-thinking decisions. Additionally, because all people have access to market information, securities are never priced too high or too low for what they’re worth.1 This belief stems from the idea that if the market is, in fact, efficient, then there is no reason for a stock to be bought at a price lower than it’s truly worth.
Another component of the MPT: by spreading your investment risk across different types of securities that have varied behavior and patterns, you are able to reduce your portfolio’s volatility while also enhancing its performance. And while you may assume an ideal portfolio means one that generates the highest possible returns, the MPT actually states that an optimal portfolio is one that balances the lowest level of risk for a given amount of return, as well as the highest return for the most logical level of risk.
Behavioral Finance: Bringing Us Back to Reality
Empirically, the MPT does not provide a strong basis for investment decision-making. While we all dream of a perfect world, unfortunately, the markets are anything but predictable. As a result, we turn to behavioral finance. Behavioral finance is all about the roles emotions and psychology play when someone is making important investment decisions. Because we are human — and far from perfect — oftentimes, our own human nature can get in the way of us making rational, predictable decisions. We are not always able to act in the most logical way possible — even if it would benefit us greatly. In fact, based on behavioral finance, investing is 80 percent psychology.2
While MPT is helpful to reference as an overarching framework for investing, behavioral finance offers a more accurate portrayal of the volatility of our own decisions, as well as the state of the market. However, by having a general understanding of both, you can merge both the ideal situation with the reality of investing to make strategic investment decisions that combine the useful knowledge of both schools of thought.
New Perspectives Offer New Opportunities
As Meir Statman, professor of finance at Santa Clara University, once said, “Traditional finance assumes that we are rational, while behavioral finance simply assumes we are normal.” When it comes to the MPT and BF, one is not necessarily better than the other, but rather, it is important to have knowledge of both to make educated investment decisions.
Modern Portfolio Theory is useful, it is more descriptive — rather than prescriptive — and the majority of the theory is based on assumptions that are oftentimes incorrect. Luckily, we have behavioral finance to add some rationality to MPT, reminding us that while we can hope the market is stable and we make logical, rational decisions, at the end of the day, we are all human, and the market’s unpredictability is vital to our own evolution and progress, as well as that of the investment world.