Asset allocation: Modern Portfolio Theory v Behavioural Finance

Karl Geal-Otter

As a theory, it attempts to explain how capital markets operate; with a long list of assumptions that don’t always hold true in the real world. Its little-known sister, Behavioural Finance (BF) is another theory that tries to explain how investors actually operate, rather than how they should operate, which is often at odds with MPT assumptions. In this article we will look at the two theories, and why asset allocators and advisors should take a few more pages out of the behavioural finance book when making allocation decisions.

Harry Markowitz was awarded the Nobel Prize in Economics in 1990, 40-years after he had developed his mean-variance optimisation – what is known today as Modern Portfolio Theory. Since his winning of the Nobel Prize, the theory has become widely used, with investors becoming more acquainted with efficient frontiers and diversified portfolios. Markowitz’ work changed what the investment industry thought of diversification.

Previously it was thought that you should hold 5 or 10 stocks and the job was done. However, Markowitz’ pointed out that the correlation between those stocks, not the number we held, had the biggest impact on diversification. For example, there would be very little diversification benefit from holding a portfolio consisting of Contact Energy, Meridian Energy and Mercury Energy with risk characteristics of each company being largely the same. Instead, Markowitz’ work would suggest holding Contact Energy, A2 Milk and Vista Group – businesses that share some risk (NZ economy) but have very different drivers; energy prices, infant formula demand and technology demand in the cinema industry. This is an overly simplified example, but a good illustration.

Modern Portfolio Theory assumes that we design our portfolios as if we are all mean-variance optimisers; rational, perfect economic beings that always make the correct decision. But, as those of you that have attended a Pathfinder presentation on behavioural finance will know, you are, in fact, irrational humans.