Modern Portfolio Theory and Behavioral Finance

Abstract

The author starts with a brief history of the ‘discoveries’ of modern portfolio theory and behavioral finance and suggests that the latter may well create just as much of a revolution in the wealth management world as the former did in institutional asset management. So which is better? modern portfolio theory, which describes how markets work, or behavioral finance, which describes how people work? The answer, of course, is that we need both. MPT and behavioral finance are both important tools in helping us design and manage successful investment portfolios. Both have advantages and disadvantages. MPT is very useful, but it is descriptive, not prescriptive, and relies on assumptions that may not always be valid. Behavioral finance picks up where modern portfolio theory leaves off, completing the circle, but the author identifies seven potential areas of weakness that can vitiate outcomes driven solely by it. He concludes by proposing an iterative combination of the two: for example, could one design the client's portfolio in the traditional manner, using MPT-based strategic asset allocation techniques and, simultaneously, design the client's portfolio using techniques informed by behavioral finance and then compare the two results in an instructive way.