Modern Portfolio Theory vs. Behavioral Finance

Modern Portfolio Theory vs. Behavioral Finance

Two different belief systems serve as the basis for most 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. While an understanding of both ways of thinking gives you a better understanding of the market, as well as your role as an investor, a primary focus on modern portfolio theory tempered by behavioral finance can enhance your overall investment experience.

Assuming the Best

There’s nothing wrong with being an optimist, but that viewpoint may serve you imperfectly as an investor in a world that is both imperfect and full of complexities we cannot control.

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, 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.

Additionally, 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 it’s truly worth.¹

Another component of the MPT: by spreading your investment risk across different types of securities with varied behavior and patterns, you can 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 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 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.

In fact, based on behavioral finance, investing is 80 percent psychology.² Because we are human—and far from perfect—our own human nature can often 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.²

While MPT serves 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 the ideal situation with the reality of investing to make strategic investment decisions that combine the valuable 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 better than the other. Rather, it is essential to know both to make 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 sometimes incorrect. Luckily, we have behavioral finance to add some rationality to MPT, reminding us that we can hope the market is stable. We want to make logical, rational decisions, but at the end of the day, we are all human. The market’s unpredictability is vital to our evolution and progress and that of the investment world.

Balance is an essential factor in any investment strategy. There is tremendous value in understanding the more profound concepts and theories involved. We employ both Modern Portfolio Theory and Behavioral Finance in the construction of our investment portfolios.