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:
- Prices are driven by emotional crowds, not fundamentals
- Investors are not rational. Therefore, markets are not efficient informationally
- The main determinant of the long term wealth are emotions
- 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.