Risk Management: Modern Portfolio & Behavioral Finance Theory

By Paul McCoy, CIMA®, AIF®

Investing strategies consist of a few different types of financial theories. This article examines two popular theories you may have heard of: modern portfolio and behavioral finance theory.

Modern Portfolio Theory (MPT)

Modern portfolio theory, also called mean-variance analysis, is a widely used model for structuring your investment portfolio. MPT was developed by Nobel Laureate Harry Markowitz, who was one of three recipients of the 1990 Nobel Memorial Prize in Economic Sciences for his theory of portfolio choice. The theory behind MPT is that investors should spread out investment portfolio risk by diversifying their holdings into safer, more stable investments with lower returns, as well as into riskier investments that may reap bigger rewards.¹

MPT examines historical data to determine which investments are considered the riskiest.

MPT makes a few upfront assumptions. The first is that the financial markets themselves are efficient. MPT also believes that investors are largely rational, with the capability of choosing an optimal portfolio. Additionally, MPT assumes that investors are largely risk-averse and would rather have more stable investments with a greater likelihood of a return, even if those returns are smaller than riskier investments.

A few MPT tenets might not appear stable if examined closely. For instance, assuming that financial markets are efficient in cycles of market volatility seems counterintuitive to empirical evidence. Getting engrossed in the rush and excitement of a bull market or a hot asset class is easy, causing many to chase after what looks like a “sure thing.” Investing using the MPT method involves examining historical data that may overlook recent market changes, potentially impacting a certain asset class or investment.

Behavioral Theory

Whereas MPT assumes that the stock market and investors are rational, behavioral finance theory examines investing through a more human lens. Behavioral economics was developed in the 1970s and is based on sociologists’ and psychologists’ assertions that humans exercise less than rational decision-making. This investing framework explores people’s actions and how they are most likely to respond in given scenarios.²

Behavioral finance theory accepts that people are unable to separate their decisions from their emotional thoughts and biases. This explains why someone might hold onto a losing asset, especially if a strong emotional feeling exists. For example, if you were gifted a stock as part of an inheritance, releasing the stock may be difficult despite its poor performance. The desire to belong and “follow the herd” is another reason that investors might feel the pain of loss from not engaging in a bull market or a certain hot investment. Behavioral finance theory also sees markets as irrational and prone to investors’ whims. If you have lived through one—or several—market bubbles and busts, this idea does not seem too far-fetched.

While behavioral finance theory can tell you a lot about yourself and your personal investing strategy, it cannot predict the markets. Although the theory may predict how you will handle the rollercoaster ride of investing, its helpfulness as a solid investment strategy remains uncertain.

Combining MPT and Behavioral Theory

Rather than viewing these two strategies as separate theories, both points of view and ideas can work together to help you become a better investor. All investment theories and styles have their pros and cons, so determining which methods work best is key. You should speak with your financial advisor to ensure that you understand each other’s investment strategies, challenge your own cognitive biases, and become a more rational investor. Answering a few questions on how you operate may offer some insight into what type of investor you are and the best methods to suit your personality.