Traditional Perspectives on Market Behavior and Portfolio Construction
Much of modern portfolio theory is premised on the efficient market hypothesis (EMH).
The EMH presumes market prices reflect all relevant available information. The aggregate decision-making of market participants is correct even if individual investors are wrong. The resulting efficient prices reflect intrinsic value and do not allow investors to earn excess, risk-adjusted returns after allowing for transaction costs.
The EMH proposes three versions of efficiency:
- A market is weak-form efficient if current prices incorporate all past price and volume data. If markets are weakly efficient, managers cannot consistently generate excess returns using technical analysis.
- If a market is semi-strong form efficient, prices reflect all public information, including past price and volume data. The moment valuable information is released, it is fully and accurately reflected in asset prices. If markets are semi-strong form efficient, managers cannot consistently generate excess returns using technical or fundamental analysis.
- Strong-form efficiency requires prices to reflect all privileged nonpublic information as well as all public information, including past price and volume data. If a market is strong-form efficient, no analysis based on inside and/or public information can consistently generate excess returns. Strong-form efficiency is not generally accepted as nonpublic information is associated with excess returns.
From a traditional finance perspective, a “rational” portfolio is one that is mean–variance efficient. The appropriate portfolio for an investor is constructed holistically by considering the investor’s tolerance for risk, investment objectives, investment constraints, and investor circumstances.
An investor will typically take or administer a risk tolerance questionnaire, document financial goals and constraints, and then adopt the output of a mean–variance model (optimized using software or human judgment) that matches the investor’s risk tolerance category and accomplishes the investor’s financial goals.
Studies Challenging the EMH: Anomalies
There are three main types of identified market anomalies: fundamental, technical, and calendar.
A fundamental anomaly is an irregularity that emerges when one considers a stock’s future performance based on a fundamental assessment of the stock’s value. Examples of fundamental anomalies are the performance of small-capitalization companies and value companies compared to large-capitalization companies and growth companies, respectively.
A technical anomaly is an irregularity that emerges when one considers past prices and volume levels. Technical analysis encompasses a number of techniques that attempt to forecast securities prices by studying past prices and volume levels.
A calendar anomaly is an irregularity identified when patterns of trading behavior that occur at certain times of the year are considered. A well known calendar anomaly is the January effect.
Alternative Models of Market Behavior and Portfolio Construction
Four alternative behavioral models have been proposed: consumption and savings, behavioral asset pricing, behavioral portfolio theory, and the adaptive markets hypothesis.
Consumption and savings: The consumption and savings approach proposes an alternative behavioral life-cycle model that questions the ability to exercise self control and suggests individuals instead show mental accounting and framing biases. Investors mentally account and frame wealth as current income, assets currently owned, and present value of future income.
Behavioral finance presumes the mental accounting for wealth by source makes individuals less likely to spend from current assets and expected future wages, but are more likely to spend from current income. Therefore, individuals will overcome at least some of their lack of self-control to save some of what they will need to meet long-term goals. This also makes them subject to framing bias. For example, if individuals perceive a bonus as current income, they are more likely to spend it. If they perceive it as future income, they are more likely to save it.
Behavioral asset pricing: Traditional asset pricing models assume market prices are determined through an unbiased analysis of risk and return. The intrinsic value of an asset is its expected cash flows discounted at a required return, based on the risk-free rate and a fundamental risk premium.
The behavioral asset pricing model adds a sentiment premium to the discount rate; the required return on an asset is the risk-free rate, plus a fundamental risk premium, plus a sentiment premium. The sentiment premium can be estimated by considering the dispersion of analysts’ forecasts. A high dispersion suggests a higher sentiment premium.
Behavioral portfolio theory (BPT): BPT assumes that investors construct their portfolios in layers, with each layer reflecting different risk and return expectations. The investor’s goals are then used to determine the allocation to each layer.
Five-Factor Process:
- Investor goals and the importance of each goal determines the allocation to each layer. If a high return for the goal is important, funds will be allocated to the high-return (high-risk) layer. If low risk is crucial to the goal, funds will be allocated to the low-risk (low-return) layer.
- Asset selection will be done by layer and based on the goal for that layer. If high return is the goal, then higher-risk, more speculative assets will be selected.
- The number of assets in a layer will reflect the investor’s risk aversion. Risk-averse investors with a concave utility function will hold larger numbers of assets in each layer.
- If an investor believes she holds an information advantage (has information others do not have), more concentrated positions will be held.
- If an investor is loss averse, the investor will hold larger cash positions to avoid the possible need to sell assets at a loss to meet liquidity needs. Additionally, securities may continue to be held simply to avoid realizing losses rather than being based on the security’s potential.
BPT investors maximize wealth, but with a constraint that wealth must have a low probability of failing to meet an arbitrary aspirational level. The investor will allocate to the low-risk layer (bonds and riskless investments) to ensure that the aspirational level is met with low risk. Once the investor is reasonably certain that the aspirational level of wealth will be met, the investor can then afford to take much more risk with her remaining portfolio.
The resulting overall portfolio may appear to be diversified but is likely to be sub-optimal because the layers were constructed without regard to their correlation with each other. Such layering can explain:
- The irrational holding of both insurance, a low risk asset, and high-risk lottery tickets by the same individual.
- Holding excess cash and low-risk bonds in the low-risk layer and excessively risky assets in the high-risk layer. (This also includes not holding more moderate-risk assets.)
Adaptive markets hypothesis (AMH): The AMH assumes successful market participants apply heuristics until they no longer work and then adjust them accordingly. In other words, success in the market is an evolutionary process. Survival is the goal rather than maximizing expected utility. Markets are driven by the competition for profit and adaptability of investors. Those who do not or cannot adapt do not survive.
Because AMH is based on behavioral finance theory, it assumes investors satisfice rather than maximize utility. Based on an amount of information they feel is sufficient, they make decisions to reach subgoals, steps that advance them toward their desired goal. In this fashion, they do not necessarily make optimal decisions as prescribed by utility theory or act as REM. Through trial and error, these heuristic rules that work come to be adopted by more and more participants until they are reflected in market pricing and then no longer work. The market evolves. AMH leads to five conclusions:
- The relationship of risk and return should not be stable. The market risk premium changes over time as the competitive environment changes.
- Active management can find opportunities to exploit arbitrage and add value.
- No strategy should work all the time.
- Adaption and innovation are essential to continued success.
- Survivors change and adapt.
AMH is essentially EMH with bounded rationality, satisficing, and evolution. In AMH, the degree to which the market is efficient will depend on the degree of competition in the market, the availability of profit, and the flexibility of participants to exploit opportunity. None of these models have been accepted by the finance community as presenting a complete picture of market behavior.