Modern Portfolio Theory vs. Behavioral Fiꦅnance: an Overview

Modern portfolio theory (MPT) and 澳洲幸运5开奖号码历史查询:behavioral finance represent differing schools of thought that attempt to exp🌟lain 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 to think of 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 1950s and 1960s by the 澳洲幸运5开奖号码历史查询:efficient market hypothesis put forth by Eugenꦆe 💫Fama of 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 澳洲幸运5开奖号码历史查询: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 澳洲幸运5开奖号码历史查询:benchmark index. In theory, it all🏅 sounds good. The reality can be a biꦐt different.

Modern portfolio theory (MPT) was developed by Harry Markowitz during the same period to identify how a rational actor would construct a diversified portfolio across several asset classes in order to maximize expected return for a given level of risk preference. The resulting theory constructed an "澳洲幸运5开奖号码历史查询:efficient frontier," or the best possible portfolio mix for any risk tolerance. Modern portfolio theory then uses this theoretical limit to identify optimal portfolios through a process of 澳洲幸运5开奖号码历史查询:mean-variance optimization (MVO).

Behavioral Finance

Despite the nice, neat theories, stocks often trade at unjustified prices, 澳洲幸运5开奖号码历史查询: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 w🎐ork—sometimes.

Perhaps the best way to consider the differences between theoretical and behavioral finance is to view the theory as a frame♌work 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 decisions. Comparing and contrasting some of the major topics will help set the stage.

Key Differences

The idea that 澳洲幸运5开奖号码历史查询: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 market𓆉 participants are privy to the same information, no one will have an advantage in predicting a return on a stock price because no one h🅘as access to better information.

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 澳洲幸运5开奖号码历史查询:behavioral finance, which look into the effects of investor psychology on stock prices, reveal some ℱpredictable patterns in the stock market.

Knowledge Distribution

In theory, all information is distributed equally. In reality, if this was true, insider trading would not exist. Surprise bankruptcies would never happen. The 澳洲幸运5开奖号码历史查询:Sarbanes-Oxley Act of 2002, which was designed to move the markets to greater levels of efficiency because the access to inform🥂ation 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 澳洲幸运5开奖号码历史查询:Wall Street stock analysts, perhaps because you have a job or a family 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 reali𓃲ty.

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 澳洲幸运5开奖号码历史查询:irrational exuberance. Similarly, nobody would buy securities when the price was high and then panic and sell ൲when 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 澳洲幸运5开奖号码历史查询:Quantitative Analysis of In✨vestor Behavior study, show that irrational behavior plays a big role and costs investors dearly.

The Bottom Line

While it is important to study the theories of efficiency and review the empirical studies that lend them credibility, in reality, markets are full of inefficiencies. One reason for the inefficiencies is that every investor has a unique 澳洲幸运5开奖号码历史查询:investment style and way of evaluating an investment. One may use 澳洲幸运5开奖号码历史查询:technical strategies while others rely on fundamentals,𒉰 and still others may resort to using a dart🎶board.

Many other factors influence the price of investments, ranging from emotional attachment, rumors and the price of the security to good old 澳洲幸运5开奖号码历史查询: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 invཧestment decisions for your portfolio ღand prepare you for the market’s reaction when others make their decisions.