MODERN PORTFOLIO THEORY & BEHAVIORAL FINANCE
Portfolio management is part science and part human behavior and we lean on studies from Modern Portfolio Theory in conjunction with Behavioral Finance to help clients design and manage investment portfolios.
Modern Portfolio Theory (MPT) is a theory of finance that attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel Memorial Prize in Economic Sciences for the theory¹, in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral finance.
MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. This is possible, intuitively speaking, because different types of assets often change in value in opposite ways².
For example the extent prices in the stock market move differently from prices in the bond market, a collection of both types of assets can in theory face lower overall risk than either individually. Diversification lowers risk even if assets' returns are not negatively correlated, indeed even if they are positively correlated³.
Behavioral Finance proposes psychology-based theories to explain stock market anomalies. Within behavioral finance, it is assumed that the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes. It argues that people are not as rational as MPT suggests and are driven by emotions such as fear and greed. The idea that psychology can drive the price of a stock directly contradicts the notion that markets are efficient.
Although none of us can accurately predict the future, we can prepare for what lies ahead. We look forward to working with you to construct a portfolio that is designed to fit your investment needs.
1. Professor Harry Markowitz 1990
2. "Managed Futures - Reducing Portfolio Volatility | A Look Into The Top 3 Managed Futures Accounts Worldwide". Emanagedfutures.com. 2011-03-19
3. Bhalla, V. K. (2010). Investment Management. New Delhi: S. Chand & Co. Ltd. pp. 587–93. ISBN 81-219-1248-2.
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