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Is Behavioral Finance Replacing Modern Portfolio Theory? Thumbnail

Is Behavioral Finance Replacing Modern Portfolio Theory?

Why Modern Portfolio Theory Still Matters

Two different systems of belief serve as the main basis for investment decisions: the modern portfolio theory (MPT) and behavioral finance. A brief explanation of the two schools of thought: the MPT focuses on the optimal market state, while behavioral finance is more focused on the actual market state. Having a solid grasp on both ways of thinking gives you a greater understanding of the market, and helps you better recognize your role as an investor. Putting a primary focus on modern portfolio theory tempered by behavioral finance might enhance your overall investment experience.

Assuming the Best

There isn’t anything wrong with being an optimist, but that viewpoint may serve you imperfectly as an investor being that we live in a world that is not only imperfect but also full of complexities that are out of our control.

If you are interested in educating yourself about the MPT, a good reference point is Eugene Fama's Efficient Market Hypothesis, which was published in the 1960s. Fama, who is known as the father of modern finance, takes an idealist approach to investments. In his theory, Fama describes a world in which the markets are efficient, where those who invest continually make thoughtful, forward-thinking decisions. Further, because all people have access to market information, securities are never priced too high or too low for what they're worth. 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 its true worth.1

Another component of the MPT: by spreading your investment risk among various types of securities with diverse patterns and behavior, you can reduce the volatility in your portfolio while enhancing its performance. While you may assume that an ideal portfolio means one that generates the highest possible returns, the MPT states that an optimal portfolio 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.1

Behavioral Finance: How Is It Different?

While we all dream of living in a perfect world, the markets are anything but predictable. Due to this fact, we turn to behavioral finance. Behavioral finance is all about the roles that emotion and psychology play when someone is making important investment decisions. In fact, based on behavioral finance, investing is 80% psychology.2 Because we are only human—and far from perfect—our human nature can often get in the way of making rational, predictable decisions. Even when it would greatly benefit us, we are not always able to act in the most logical way possible.

While MPT is helpful to reference as an underlying framework for investing, behavioral finance offers a more authentic representation of the impact of our own decisions, as well as the state of the market. By maintaining a general understanding of both MPT and behavioral finance, you can blend the ideal situation with the reality of investing to make strategic investment decisions that intermix the valuable insight 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 behavioral finance, one is not necessarily better than the other. Rather, knowing both is the key to making educated investment decisions. 

Modern Portfolio Theory is valid; it is more descriptive rather than prescriptive, but most of the theory relies on assumptions that are frequently incorrect. Thankfully, we have behavioral finance to add some rationality to MPT, reminding us that we can hope the market is stable. While we want to make logical, rational decisions, at the end of the day, we are only human. The market's unpredictability is vital to our progress and that of the investment world.

Balance is an essential factor in anyone’s financial strategy. There is value in having an understanding of the more profound concepts and theories involved. For that reason, you should take time to research these concepts and bring any questions you might have to your trusted financial professional so that they can help deepen your understanding of both concepts.

  1. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/efficient-markets-hypothesis/
  2. https://www.researchgate.net/publication/283488173_Behavioral_Finance_The_Psychology_of_Investing