With the recent ups and downs of the market, many clients are asking our advisors about how they can manage their risk exposure. In today’s article, we are introducing two popular investing theories: modern portfolio and behavioral finance theory.
Modern Portfolio Theory (MPT)
Modern portfolio theory, also called mean-variance analysis, is a widely used model for structuring your investment portfolio. Developed by Nobel Laureate Harry Markowitz, the theory behind MPT is that investors should spread out investment portfolio risk by diversifying their holdings into safer, more stable investments with lower returns, as well as into riskier investments that may reap bigger rewards.1
The theory starts with a few upfront assumptions. First, that the financial markets themselves are efficient. Then, that investors are largely rational and have the capability of choosing an optimal portfolio. Additionally, MPT assumes that investors are largely risk-averse and would rather have more stable investments with a greater likelihood of a return, even if those returns are smaller than riskier investments.
It may seem counterintuitive to assume that financial markets are efficient, especially during times of market volatility as we have been experiencing lately. MPT relies on historical data, not just short periods of time. That’s why we see a lot of investors get too excited during a bull market or too fearful during a bear market. It can be difficult for the average investors to consider historical data and not become too engrossed in what they are experiencing at the very moment. Investing using the MPT method involves examining historical data that may overlook recent market changes, potentially impacting a certain asset class or investment.
Behavioral Finance Theory
Taking an alternative stance to the MPT assumption that the stock market and investors are rational, the behavioral finance theory examines investors through a more emotional standpoint. Behavioral economics is based on experts’ assertions that humans exercise less than rational decision-making and explores how people are most likely to react in given scenarios.2
It can prove difficult for many people to separate their decisions from their emotions and biases. For example, an investor my hold on to a losing asset just because they feel an emotional attachment to it, or they may purchase a “hot” investment because they have heard a lot about it. The behavioral theory also helps explain why they may sell an investment for a loss in a bear market because they are too fearful that the market will continue to decline and do not have the patience for its eventual rebound. Behavioral finance theory also sees markets as irrational and prone to investors’ whims. If you have lived through one—or several—market bubbles and busts, this idea does not seem too far-fetched.
While behavioral finance theory can tell you a lot about yourself and your personal investing strategy, it cannot predict the markets. That’s why its important to work with a financial advisor who considers your personal risk tolerance level and can help you manage your emotions when it comes to making investment decisions.
Combining These Theories to Manage Risk
We believe combining the viewpoints of these two strategies can help you become a better investor. Like any investment theory, MPT and behavioral finance theory have their pros and cons so you should speak with your financial advisor to make sure you fully understand these theories before making any investment decisions. Your advisor can help you create your own unique risk profile by answering a few questions and then build a financial plan that best suits you and your family.
This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.