There are two dominant belief systems when it comes to investment decisions: the modern portfolio theory (MPT) and behavioral finance (BF). Each has its merits but understanding both is essential for a well-rounded view of the market. The MPT focuses on the "ideal" state of the market, while BF considers actual market conditions. By understanding both schools of thought, you gain a more complete picture of how investments work - and can make better choices about your portfolio.
What is MPT and how does it work
MPT assumes that investors are smart and always make rational decisions. According to MPT, stock prices should never be too high or low for what they're worth, because the market always adjusts to reflect true value. This theory rests on the assumption that investors are rational and always make the most logical choices possible - in other words, they never panic or get emotional.
The theory also seeks to find the most efficient way to spread risk to achieve the best possible return, by considering correlations between the level of risk and potential return. MPT has been the foundation of modern finance for decades and is still used by many experts today to create well-diversified portfolios that minimize risk under perfect market conditions.
MPT has been around for a long time - it was developed in the 1950s by Harry Markowitz. And although some aspects of his theory have been proven false (such as the idea that all investors are rational), it remains a useful tool for financial advisors.
How Behavioral Finance challenges the assumptions of MPT
Behavioral finance takes into account the fact that investors are not always rational and can often be influenced by their emotions. In other words, BF recognizes that people often make poor decisions based on fear or greed, rather than logic. Sometimes investors will act irrationally even after they realize their mistake, either because they can't bear to take a loss or are convinced that their original prediction was correct.
This school of thought attempts to understand emotional reactions and predict how markets will react under different circumstances - including when fear drives up prices beyond what's justified. BF looks at how emotions, biases, and social influences affect investment choices.
Behavioral finance was developed in the late 1970s by two professors, Daniel Kahneman and Amos Tversky. BF has gained traction in recent years, as more and more evidence has shown that investors are not always rational. For instance, we know that "investing is 80% psychology". This means the decisions people make are often based on emotions, not reason, and on perceived risk/return ratios, rather than actual ones.
Both MPT and behavioral finance have their strengths and weaknesses
Although MPT is based on several optimistic assumptions (mainly, that the market is efficient), it remains the dominant belief system when it comes to investment decisions. While growing in popularity, behavioral finance has not yet supplanted MPT as the primary way of thinking about investments. However, an understanding of both schools is essential for a well-rounded view of the market.
MPT makes sense in a perfect world where securities are relatively priced, and the economy is always growing. But, we know that markets fluctuate based on imperfect decisions and forces beyond our control - so it's essential to understand how these forces can impact your investments. A well-balanced portfolio allocates assets across different sectors to diversify risk while maximizing return potential over time (i.e., long term).
In the end, it is important to remember that no one theory can explain everything about the market. The best approach is a balanced one that incorporates MPT and behavioral finance. By doing so, you can gain a more complete understanding of how investments work – as well as your role as an investor – and can make wiser choices when it comes to your own portfolio.
Why seek advice from a fiduciary?
There are a few key reasons why you should seek advice from a fiduciary when it comes to MPT and Behavioral Finance models:
- They have a deep understanding of the concepts involved and can help you apply them to your specific situation.
- They are unbiased and will always put your best interests first.
- They have the experience and expertise to help you make informed decisions about your investments.
It's always a good idea to get expert advice. A fiduciary is legally obligated to put your interests first. This means they will not benefit from recommending products that are not in your best interest - and they have a duty to disclose any potential conflicts of interest. You can have peace of mind knowing that they provide honest, unbiased guidance.
By working with a fiduciary, you can be confident that you are receiving an expert's perspective that incorporates aspects of both theories to assist you in making well-informed decisions. A fiduciary will assist you in determining how these two ideas apply to the current market and your circumstances, as well as offer recommendations based on your personal investing style.
If you have questions about how applying these concepts can help you make better investing decisions, or if you would like more information, please contact us today. We would be happy to help!