The central tenets of modern portfolio theory and beliefs in rational markets have been found wanting. Critics have observed that Sharpe’s “Capital Asset Pricing Model” (CAPM) and the Modigliani-Miller theorem were written during periods of extreme market stability. The standard neoclassical model assumes that an extraordinary expectation of rationality that people carry out a full rational analysis of all their available options when making decisions. Life and behaviour are not like this.
With the effects of the global financial crisis still resonating in markets around the world, many of the belief systems of classical economics and portfolio theory have found themselves challenged.
Rising slowly in an attempt to replace many of these beliefs is a new social science, a namely that of behavioural economics and finance. Collectively known as behavioural science, it is worth noting the distinction between the two strands, which are often used interchangeably.
It is prescient to start with economics, as it is here where we find the first traces of obsession with rationality. Classical economists, partly in a worthy effort to model the aggregate and partly in a snobbish effort to up weight their discipline, used dubious assumptions about human rationality in order to make the maths sitting behind neat and tidy. Unfortunately, despite notable warnings from Thorstein Veblen that the departure from reality would prove too great, the march toward a more ‘scientific’ approach continued unabated. As Robert Heilbroner reminds us in his bestseller The Worldly Philosphers, “Man, said Veblen, is not to be comprehended in terms of sophisticated “economic laws” in which both his innate ferocity and creativity are smothered under a cloak of rationalisation.”
The siren call of neat and tidy mathematics entrapped the finance industry too. But, again, regrettably the central tenets of modern portfolio theory and beliefs in rational markets were flawed and have been found wanting.
Opponents of efficient market hypothesis point to Warren Buffett and other investors who have consistently beat the market by finding irrational prices within the overall market. Indeed, Warren Buffett once said he’d be a bum on a street with a tin if markets were always efficient. Our own Hugh Young, Aberdeen’s group head of equities, is just as forthright about his views on the theory: “The efficient-market hypothesis is nonsense. Markets are driven by humans, humans are irrational, and thus markets are irrational.”
Questioning the validity of modern portfolio theory may have serious consequences for fund managers. Critics have observed that Sharpe’s “Capital Asset Pricing Model” (CAPM) and the Modigliani-Miller theorem were written during periods of extreme market stability. Modern Portfolio Theory (MPT) was written in 1959 and Modigliani-Miller’s papers during the early 1960s. During the great bull market runs, MPT seemed to perform well but in current market conditions, its cracks are truly showing. The volatility approach in MPT and Sharpe’s model values downside volatility and upward moves equally. But such an approach is flawed in the current market environment. And any student of “loss aversion” will know that such neutrality fails a common sense test.
Ned Goodman of Canadian asset manager the Dundee Corporation pithily explained the shortfalls of conventional approach to asset management in 2008. saying: “Investment has not kept up with the cutting edge intellectual developments. While the science of irrational behaviour is quickly growing up, conventional wisdom still provides investment advice based on very outdated, bogus ideas of sensible sane people and rational stock markets. The extremes of human emotion prevent the stock market from spending much time in a rational state of fair valuation. The stock market has multiple personalities: extreme state of happiness to severe depression. The stock market rarely behaves in an average manner.”
The necessity to prefix economics and finance respectively with the word ‘behavioural’ is a sign of just how carried away academics and finance professions pushed the rational envelope. Richard Thaler, one of the fathers of behavioural finance, famously predicted that the term “behavioural finance” would become a redundant phrase, stating “what other kind of finance is there?” The sentiment obviously applies to ‘economics’ as well.
The sober reality is that behavioural science does not hold all the answers either. It identifies many of the flaws and eloquently explains them, but in terms of solutions, we are still left with the headache of creating a macro, aggregate model based ‘irrational’ individual behaviour. The good news is that is that through the flourishing discipline, we now have a far better starting point as we are at least beginning to get to grips with why we actually behave the way we do.
Our natural bias, like the empiricist eighteenth century philosophers John Locke and David Hume, is through observation and seeking evidence, finding the more abstruse mathematical and cold logic of Descartes harder to follow. We are predominantly a fundamental investor and an intuitive supporter of behavioural finance.
