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Modern portfolio theory (MPT) is questioned by many in the financial advisory industry and for good reason. An ever-growing empirical research stream soundly rejects the three MPT pillars of mean-variance optimization, the capital-asset pricing model (CAPM) and the efficient markets hypothesis (EMH).
On the other hand, 40 years of behavioral science research provides a more realistic framework for viewing investors and markets.
Researchers Daniel Kahneman, the late Amos Tversky, Robert Shiller, Richard Thaler, Hersh Shefrin and Meir Statman, among others, are leading the transition to behavioral finance, as the MPT theories of Harry Markowitz, William Sharpe, and Eugene Fama fade into history.
Contrary evidence piles up
The empirical onslaught against MPT began in the late 1970s. The initial CAPM tests uncovered a negative return to beta relationship (i.e., low-beta stocks performed better than expected). Rather than reject CAPM, however, the discipline responded by searching for statistical problems in those tests. Yet, virtually no evidence supporting the CAPM has been forthcoming.
The EMH first came under attack when Sanjay Basu’s research demonstrated that low-P/E stocks outperformed high-P/E stocks. In the early 1980s, Rolf Banz showed small-cap stocks outperformed large-cap stocks. The problem, of course, is that both P/E and firm size are public information and should not allow investors to earn excess returns. There are now hundreds of empirically verified anomalies.
Proponents argue that the EMH remains viable as long as active equity managers cannot use anomalies to earn excess returns. But for the last 20 years, multiple studies have shown that many active equity managers are superior stock pickers and do indeed earn excess returns on their holdings. Russ Wermers demonstrated that the average stock held by active equity mutual funds earns a 1.3% alpha, and Randolph B. Cohen, Christopher Polk, and Bernhard Silli found that ex-ante best-idea stocks earn a 6% alpha.
In the early 1980s, Robert Shiller argued that almost all volatility observed in the stock market, even on an annual basis, was noise rather than the result of changes in fundamentals. Since EMH held that prices fully reflect all relevant information, volatility driven by anything other than fundamentals strikes at the very heart of the theory.
Shiller’s noisy-market model also created problems for Markowitz’s portfolio optimization. If volatility is the result of emotional crowds, then emotion has been placed in the middle of the portfolio construction process. So rather than being a risk-return optimization, it is an emotion-return optimization
Rejecting the evidence rather than the theory
Much of the leadership in finance pushes aside the mounting contrary evidence and soldiers on under the yoke of MPT. This is surprising. Isn’t finance a discipline based on empiricism, one that only accepts concepts supported by evidence? Unfortunately, as Thomas Kuhn argued years ago in his classic work, The Structure of Scientific Revolutions, scientific and professional organizations are human and are susceptible to the same cognitive errors that afflict individual decision making.
The concepts underlying MPT have not been universally rejected. Instead, they are widely used in studies and show up in textbooks all over the world. MPT’s ubiquity confirms its legitimacy through social validation rather than empirical evidence. Emotional decision making is rampant in what is supposed to be a rational discipline.
The profession’s unease
But in spite of official acceptance, many in the industry do not believe in MPT’s underlying assumptions: investors are rational and markets are informationally efficient.
Howard has presented to thousands of advisors and analysts and each time polls the audience, asking how many of them have at least one rational client. Over the years, fewer than 10 hands have been raised! So why are we using, they wonder, a paradigm based on the assumed existence of an economic agent that is so rarely encountered?
Advisors must view investors and markets as they are and not as we would like them to be. In a recent presentation at the CFA Institute Annual Conference, Howard proposed the following behavioral concepts:
- Market prices are mainly driven by emotional crowds not fundamentals
- Investors are not rational; markets are not informationally efficient
- Emotions are the most important determinant of long-horizon wealth
- There are hundreds of market anomalies that can be used for building superior portfolios
He then polled the hundreds of advisors and analysts in attendance, asking them if they agreed with one or more of these concepts. Virtually every hand went up!
The empirical evidence is supportive of these behavioral concepts. But even more important, industry professionals are already employing them when dealing with investors and markets.
Implementing behavioral finance
While many accept the concepts underlying behavioral finance, the question frequently arises, “How do I implement these concepts in my practice, and is this even possible?” The answer is “yes” and there are specific steps an advisor can take.
By implementing behavioral finance concepts in one’s practice a realistic view of investors and markets is adopted. This adoption allows one’s practice to deliver the best value to its clients. Here are four ways advisors can help clients thrive in a post-MPT world:
- Needs-based planning
The primary benefit of needs-based planning is fostering client confidence that needs are being met, which in turn reduces the chance of emotional decisions when managing client portfolios.
Needs-based planning is where a client’s portfolio is partitioned into liquidity, income and growth “buckets,” for example, with each funded separately to meet a specific need.
The liquidity bucket is funded using low- or no-volatility securities, such as bank accounts or money market funds.
High-yield stocks are an attractive investment for funding the income bucket, as less is required to generate the needed income and dividends grow faster than inflation. However, other high-yield alternatives, such as MLPs, also make sense.
Stocks are the best investment for building wealth in the growth bucket. The ideal is 100% stocks since equities have the highest expected return of any asset class.
However, client comfort is an issue, so even with skilled emotional coaching on the part of the advisor, it is often not possible to reach this goal.
The underlying concept here is an emotion-return tradeoff and not a risk-return tradeoff. Don’t rationalize by calling it a risk discussion. True risk in this situation is the reduction in long-horizon wealth that results when investing in low-expected return securities such as bonds.
- Volatility is not risk
When building long-horizon wealth, volatility is not risk, but is, instead, the emotional residue of investing in equities and other high-return markets.
The concept of volatility as risk rests on a critical assumption that is overlooked by most of the industry: only in finance is risk defined as volatility or the bumpiness of the ride. Why? In the 1950s, academics recognized that hundreds of years of statistics research could be borrowed to analyze the performance of investment portfolios – if some of the definitions could be bent to satisfy their needs. Once standard deviation was transformed into “risk,” the work of analyzing portfolios could begin and theories could be developed.
Nobel laureate Robert Shiller showed that stock prices fluctuate much more than the underlying dividends, their source of value, in his seminal paper. The implication is that stock-price changes are largely driven by something other than changing fundamentals. Volatility is the result of investors’ collective emotional decisions. Shiller’s contention is still true. Numerous studies have attempted but failed to dislodge it.
- Cult of emotion
“I know you are afraid and you should be afraid. I will only invest you in products that will not stir up your fears.”
This sentiment is applied over and over again in the investment industry in one form or another.
It is the mantra of what we call the “cult of emotion.” The cult is so pervasive, advisors are hardly aware how it affects virtually every investment decision they make. It has been institutionalized through regulation, cult enforcers (platforms, gatekeepers, analysts, consultants) and even MPT.
Investors are prone to a host of cognitive errors when in the thrall of emotions. The two most prominent are myopic loss aversion and social validation. Research into myopic loss aversion demonstrates that people experience the negative feelings associated with losses almost twice as acutely as the pleasure of gains and they react to these short-term emotions even when facing a long-term investment horizon. Social validation, on the other hand, is our innate desire to follow and be a part of the herd.
As advisors, we can do little to turn off these emotions. But we can decide how we respond to our clients when they experience them in the growth bucket of their portfolios.
There are two choices: cater to clients’ emotions or strive to mitigate the damage inflicted by investment decisions made based on those emotions. Investors left to their own devices will let their feelings drive their investment choices. And that will end up costing them hundreds of thousands – if not millions – of dollars in long-term wealth. By helping to short-circuit these cognitive errors, advisors and analysts can add value for their clients.
Investors are fearful and their fears need to be addressed by their advisor. Some investors can’t be talked out of their fears. But advisors need to do all they can to help clients avoid these expensive mistakes.
- Cult enforcers
Sadly, cult enforcers encourage us to cater to, rather than mitigate, client emotions. For example, current practice is to diversify across multiple asset classes regardless of the expected return. The result is a trade-off between short-term emotional comfort and long-horizon wealth. Enforcers sanction this practice, so we don’t recognize the damage it inflicts on client portfolios.
A considerable swath of the industry is influenced by a suitability standard. Clients are required to complete a “risk assessment” and are then categorized as conservative, moderate or aggressive. The growth portion of a portfolio is then constructed to fit this classification.
But suitability is an emotional assessment of clients – and a poor one, at that – not a risk assessment of their portfolios. This is an absolutely critical distinction. Suitability legitimizes the construction of low-return portfolios for temporary peace of mind and consequently denies clients substantial long-horizon wealth.
Enforcers view tracking error as risk. It’s not. It is an emotional trigger for investors. Because of myopic loss aversion, short-term underperformance serves as a signal to sell a fund and invest in another with better recent performance. Thus, enforcers require low tracking error. But truly active funds can’t be successful without tracking error. Accommodating the feelings evoked by tracking error costs investors dearly.
The transition is upon us
After decades of research, there is little evidence supporting MPT. As a result, the industry is in the midst of a transition from MPT to behavioral finance.
The investment world is changing rapidly. As Kuhn observes, when paradigms change, everything changes, including basic concepts, facts, history, tools and methodologies.
When the transition is complete, little of MPT will remain.
The ultimate irony of rationally-based MPT is that it gives advisers and analysts the tools to enforce the cult of emotion, including volatility as risk, efficient frontier, downside capture, downside risk, R-squared and the Sharpe ratio.
The law of unintended consequences should not have the last word. As MPT fades into history, so will these tools. This is another step in the transition to Behavioral Finance.
Studies reveal an advisor, in his or her role as a skilled emotional planner and coach, can improve client outcomes by around 300 basis points. Needs-based planning, thinking of volatility as emotion rather than as risk, and leaving the cult of emotion are tangible steps an advisor can take to deliver increased value to clients.
Indeed, there is life after MPT.
Thomas Howard is Professor Emeritus, Reiman School of Finance, Daniels College of Business, University of Denver and CEO and Chief Investment Officer, AthenaInvest, Inc.
Contact information: [email protected] (877) 430-5675 x100.
Jason A. Voss, CFA, is the retired co-portfolio manager of the highly successful Davis Appreciation and Income Fund. Currently he is Director of Content for CFA Institute and its 150,000+ members in over 140 countries. Contact information: [email protected]
See our recent CFA Enterprising Investor Blog The Active Equity Renaissance.
Read more articles by C. Thomas Howard, PhD and Jason Voss, CFA