Apparently, there’s life after modern portfolio theory


#1

Modern Portfolio Theory began in 1952, with Markowitz paper “Portfolio Selection”, where it introduced the concept of mean-variance optimization. This idea revolutionized the finance world ending up being used in other important models such as Sharpe’s CAPM, or Fama’s EMH. However, C. Thomas Howard is the antithesis of this theory. Howard claims himself to be a “behavioral financial analyst”. With this he claims that markets are not efficient, and that investors need to conquer their behavioral biases. He wants people to see the market as they actually are, and not what we want them to be in theory. To support his philosophy of markets he gave four principles:

  1. Prices are driven by emotional crowds, not fundamentals
  2. Investors are not rational. Therefore, markets are not efficient informationally
  3. The main determinant of the long term wealth are emotions
  4. Anomalies, or behavioral price distortions can be used for building better portfolios.
    Howard also mentions that there “cult enforcers”: agents who still believe that the market is efficient and nudge market participants from making better allocations. His main conclusion is that building a better portfolio is pretty straightforward, but emotionally challenging. It is hard to let go of the strong market theories.

I found this article interesting. Howard believes in signaling, and prices being driven by emotions, not just plain numbers. Agents are irrational, and have feelings, this gives space for broader theories that can include more realistic assumptions about the market and its participants.

To read more about it:
https://blogs.cfainstitute.org/investor/2017/06/01/c-thomas-howard-view-the-markets-as-they-are/


#2

Hi Melissa,
I believe this a very interesting approach to finance and investment portfolio decisions. As Thomas Howard, many analyst and market participants believe that the prices in the market are not always a pure reflect of their fundamental value. At the end of the day, stocks are unpredictable because their prices (in markets) are driven by human emotions and behavior.

In the last years, behavioral finance has gain widespread acceptance by regulators and academics. Technical analysis tools have been widely undertaken as a way to analyze the market sentiment and approach this “inefficiencies” in the market (it’s even a topic in the CFA study guide). This video provides a quick introduction to some of this tools that I find very intersting.

Related to the same topic, I found this article from Andrew Lo where he describes a new method that tries to link the traditional models of modern financial economics (like Portfolio theory, CAPM, Sharp, etc.) with behavioral models in an intellectually consistent manner. In sum, he finds out that many of the “violations” to efficiency that behavioral analysis find in the markets are actually consistent with a model of individuals adapting to a changing environment. Based on this idea, he describes a method called “The Adaptative Markets Hypothesis” (AMH) that consists mainly of 6 ideas:

  1. Individualsactintheirownself-interest.
  2. Individuals make mistakes.
  3. Individuals learn and adapt.
  4. Competition drives adaptation and innovation.
  5. Natural selection shapes market ecology.
  6. Evolution determines market dynamics.

Based on this system, he describes posible applications of such model in asset allocation and the measurement and management of preferences.

Finally, here is the link to the original paper in case you or anyone else want to read more on the topic:
Reconciling Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis