MVT 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:
- Investors are rational
- Markets are efficient
- Investors should design their portfolios according to the rules of mean-variance portfolio theory and do
- Expected returns are a function of risk and risk alone and beta is used to measure risk.
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?
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