Lisa Gray has been a wealth writer since 2001. She has been involved in the wealth management industry since 1988. She is the author of two bestselling books—The New Family Office and Generational Wealth Management.| Modern Portfolio Theory Or Behavioral Portolio Theory...Is The Only Choice To Utilize One Over The Other? |
 |
| Wednesday, May 02, 2012 13:45 |
|
Modern portfolio theory (MPT) or mean-variance portfolio theory (MVT) has taken its knocks in the investment world. Especially during the 2008 crisis, the media splashed headlines that MPT was dead. And behavioral portfolio theory (BPT) often seems to be fighting an uphill battle as a legitimate basis for portfolio construction.
What if there were a third option that offered clients a more optimal solution? This Website Is For Financial Professionals OnlyMVT and BPT. Like our politically divided country, advisors and analysts divide into one camp or the other and dig in their heels.
Each theory has its merits. Each theory is proven in academic and practical application. But neither theory applied in totality offers clients optimal results in achieving their goals.
Creating a third option would mean combining best components of each theory into a single application that is better aligned with clients' expectations and wishes.
That’s exactly what Harry Markowitz, Meir Statman, Sanjiv Das, and Jonathan Scheid did in 2010.
Standard finance—the other name for MPT and MVT—functions utilizing the capital asset pricing model (CAPM) to justify investment. CAPM assesses the time value of money (the risk-free rate of return) and the additional risk needed to achieve a premium above that risk-free rate of return.
CAPM assumes four things:
As long as the investor we’re talking about has no taxes to pay and only a single goal, MVT works just fine. Institutional money dominated the markets until the mid-1980s when the consulting model began to be applied to individual investors on a massive scale.
As individual wealth grew and asset managers adjusted their models to accept groups of individuals with the same size assets as institutional accounts, individual wealth began to predominate.
Before individual investors became involved in the capital markets, the institutional model was all that mattered. The work of Gene Fama, William Sharpe, Harry Markowitz, and others were based on this model.
Once the bulk of the money changed hands, it made sense that a new model would be needed to reflect the different characteristics of investors.
This is where behavioral finance comes in and the characteristics of individuals begin to matter.
Individual investors are not rational. They are normal (as opposed to irrational). They make decisions based on emotions. That’s what behavioral finance is all about.
This is a real component of the market because people’s reactions out of fear or exuberance move the markets—sometimes to significant extremes.
By taking the best components of MVT and BPT, an even more effective portfolio construction can be formulated based on a framework utilizing mental accounting (MA). In this model, some components of MVT are enhanced and others are replaced.
MA offers a different response to the four assumptions of CAPM. In a nutshell, it enables sub-portfolios to be created that more directly match the multiple goals of individual investors.
If there’s a better way to help clients achieve their goals and effectively protect their assets in the process, isn’t that a method worth considering?
Comments (3)...
Hi, Brent, Thank you for making that distinction. The paper written by Markowitz and Statman, et al indeed mentioned both MVO and MPT but did not equate them. I should have made the distinction more clear. Thank you for doing that for me.
What strikes me with the MA approach is that Markowitz endorses it along with prominent behavioral experts like Statman. I find the integration of their work fascinating and compelling.
,
May 03, 2012
...
Great article Lisa, my point was more to reiterate for the readers of A4A of the difference, not in an attempt to point out a flaw in your posting.
What is interesting is that registered reps under FINRA have a regulatory environment that requires the use of MVO. RIAs could exploit this opportunity by embracing new, robust, peer reviewed optimization methods.
,
May 03, 2012
Write commentYou must be logged in to post a comment. Please register if you do not have an account yet.
|
Many people cite Portfolio Selection (the seminal paper that Markowitz introduced MPT in the 50s) without ever having read or verified their references against Markowitz's research and writing. What few fail to ever realize that in the original paper, Markowitz himself alluded to a much better method for optimization, using semi-variance. However in the 1950s he understood that semi-variance was too complex a calculation for wide acceptance.
What is most compelling is he has been troubled for years that financial planning incorporates MVO, something he readily admits was never intended as it problematic as you describe above because it ignores the clients goal and replaces them with CAPM.
The work they did was/is an attempt to overcome the belief that the only way to implement MPT is via MVO, but everyone views MPT and MVO as one in the same!