How to Invest: A Tale of Two Investment Theories

My first exposure to investment theories was during an economics class I took in college. I was always sort of a geek when it came to graphs and numbers—which I guess explains my degree in statistics—so I was captivated when the professor drew an example of the efficient frontier on the chalk board. It made perfect sense to me.

In theory, there existed a perfect combination of assets such that one could achieve the maximum level of potential return for any given level of risk.  The idea, commonly referred to as modern portfolio theory, has made a huge impact in the investment world since its introduction by Harry Markowitz in the 1950’s.  Today, almost every institutional and private money manager uses some form of modern portfolio theory to advise their clients on how to allocate their investments but is modern portfolio theory really all it’s cracked up to be?

Some critics of modern portfolio theory believe the theory has problems that stem from poor assumptions and a new field of study called behavioral finance is raising a challenge to the theory’s conventional wisdom.  Proponents of behavioral finance suggest that there is a psychological component to the way people invest that is not accounted for in modern portfolio theory. For example, take the following three assumptions applicable to modern portfolio theory: investors are averse to risk, investors are rational, and investors have equal access to information that influences the way they invest.  A proponent of behavioral finance might suggest that investors are more averse to loss than risk, are irrational when it comes to making investment decisions, and are predisposed to certain biases that influence the way they invest. Depending on which school of thought you subscribe to, here are some investment strategies to consider:

For Proponents of Modern Portfolio Theory

If you are a proponent of modern portfolio theory, you should look for tools and resources that can help you develop a disciplined investment strategy.  Asset allocation websites like http://www.aaii.com/asset-allocation and https://www.calcxml.com/do/inv01 are a good place to start.  Also, check with your employer to see if they offer online advising services from companies like Financial Engines or GuidedChoice.

Once you have your investment strategy in place, initiate auto-rebalancing.  If your investment provider does not offer auto-rebalancing, set up a periodic reminder (at least once a year) to re-balance manually.  Re-balancing will help keep your allocation in line with your strategy and reduce the temptation of emotional investing.

Over time, your financial goals, circumstances and/or time horizons may change.  Make adjustments to your portfolio as needed based on these changes. If you are not able or willing to take the action steps described above, then at least use a managed account or target date fund to accomplish much of the same thing.

For Proponents of Behavioral Finance

If you are a proponent of behavioral finance and believe that markets are inefficient and affected by investor biases, then you may want to use one of two methods for making investment decisions: fundamental analysis or technical analysis. An investor that uses fundamental analysis attempts to determine the value of a company’s stock price by analyzing the company’s financial statements.  If the investor determines that the stock price is overvalued, the investor would want to avoid buying the stock, sell a current position, or short the position.  By contrast, if the investor determines that the stock price is undervalued, the investor would want to keep any existing positions, acquire new shares through direct purchase, or purchase a call option.

An investor that uses technical analysis is not interested in the characteristics of the company but rather the behavior of investors.  Technical analysis involves reading charts (which is why they are sometimes referred to as chartists). What they are looking for is certain patterns that may precede a change in the stock price.

Neither approach is superior to the other. Like most things, it really boils down to user preference. But if you don’t have a lot of time and interest to devote to understanding behavioral finance, then perhaps your best bet is to stick with the method most often used by the pros: modern portfolio theory.

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