Why Modern Portfolio Theory Still Matters
Why Modern Portfolio Theory Still Matters
Two different belief systems serve as the basis for investment decisions: the modern portfolio theory (MPT) and behavioral finance (BF). A basic summary of the two schools of thought: the MPT focuses on the optimal state of the market, while BF is more focused on the actual state of the market. While an understanding of both ways of thinking gives you a better understanding of the market, as well as your role as an investor, a primary focus on modern portfolio theory tempered by behavioral finance may enhance your overall investment experience.
Assuming the Best
There’s nothing wrong with being an optimist, but that viewpoint may serve you imperfectly as an investor in a world that is both imperfect and full of complexities we cannot control.
If you're interested in learning more about the MPT, a good reference point is Eugene Fama's Efficient Market Hypothesis, published in the 1960s. Fama, known as the father of modern finance, takes an idealist approach to investments. In his theory, Fama describes a world in which the markets are efficient, where those who invest continually make thoughtful, forward-thinking decisions. Additionally, because all people have access to market information, securities are never priced too high or too low for what they're worth. This belief stems from the idea that if the market is, in fact, efficient, then there is no reason for a stock to be bought at a price lower than it's truly worth.1
Another component of the MPT: by spreading your investment risk across different types of securities with varied behavior and patterns, you can reduce your portfolio's volatility while also enhancing its performance. And while you may assume an ideal portfolio means one that generates the highest possible returns, the MPT states that an optimal portfolio balances the lowest level of risk for a given amount of return, as well as the highest return for the most logical level of risk.1
Behavioral Finance: How Is It Different?
While we all dream of a perfect world, unfortunately, the markets are anything but predictable. As a result, we turn to behavioral finance. Behavioral finance is all about the roles emotions and psychology play when someone is making important investment decisions. In fact, based on behavioral finance, investing is 80 percent psychology.2 Because we are human—and far from perfect—our own human nature can often get in the way of us making rational, predictable decisions. We are not always able to act in the most logical way possible, even if it would benefit us greatly.
While MPT is helpful to reference as an overarching framework for investing, behavioral finance offers a more accurate portrayal of the volatility of our own decisions, as well as the state of the market. However, by having a general understanding of both, you can merge the ideal situation with the reality of investing to make strategic investment decisions that combine the valuable knowledge of both schools of thought.
It's important to be aware of our own behavior in any situation that we face. Most of us have developed patterns, habits, and ways of doing things over decades of our lives. Some of our habits might be ingrained or taught from our parents or mentors, others perhaps from situations or careers that shaped our behavior to yield certain desired results. Whatever the case, the more we are familiar with our propensity to act a certain way, the better we can be prepared to handle stressful situations or even full-blown crises.
The bible teaches us that we are three-part beings: Spirit, Soul, and Body. In any given scenario, we can act in any combination of the three. Just like in the physical context of developing our bodies through exercise, we can also develop our behavior to yield more desirable outcomes. In the case of our financial behavior, maintaining discipline, an even demeanor, and seeking wise counsel all help us to maintain our trajectory towards reaching our long-term financial goals in the face of instability.
Evergreen Financial Group is a Fee-Only Financial Planning and Investment Firm located in Billings, MT serving clients in Montana, Wyoming and virtually across the country. Evergreen Financial Group specializes in working with Christian families, including young professionals, Current and Future Retirees and Church Staff Members.
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