We have questioned many orthodoxies of modern portfolio theory (MPT) in this series, challenging currently accepted models of financial markets and exploring the decline of MPT and the folly of using volatility as a measure of investment risk.

But in undermining the foundations of MPT, what do we propose to take its place?

Behavioral Finance Is a More Promising Alternative

It is time to move away from MPT to a more promising alternative: behavioral finance. The analytical tools derived from behavioral finance’s more realistic representation of financial markets and human behavior will likely replace the wealth-limiting MPT tools in use today. Sadly these same outdated and ineffective MPT tools help select and evaluate active equity managers. Abandoning such obsolete instruments is critical to ushering in The Active Equity Renaissance.

A fully developed behavioral model of financial markets does not yet exist, but several underlying concepts and their resultant implications for investment management are emerging.

A Prospective Investment Framework

Financial markets are populated by human investors burdened with emotional baggage and associated cognitive errors. In a market context, these errors are amplified because, in the aggregate, they create herding, which leads to wild price swings. Rampaging emotional crowds cause extreme volatility of returns in financial markets. Look no further than equity market price bubbles for evidence of these rampaging emotions.

Behavioral Concept 1: Emotional crowds, not fundamental changes, drive price movements in financial markets.

Financial markets cannot be neatly packed into a set of mathematical equations. Markets are messy, and the only way to make sense of them is to view them in all their disorder.

We will never understand why markets and their underlying securities move the way they do over shorter time periods. So if we’re asked why the market, a stock, or other security moved the way it did on a particular day, the honest answer is almost always, “I have no idea.” In fact, research demonstrates that only a minute percentage of the market transacts on any given day. Yet, investors and investment journalists always ascribe a rationale to market movements even when the implied causality is chimerical. Unsettling as this may be, it is an effect of our first behavioral concept: Emotions — not fundamentals — are the main movers of financial markets.

Behavioral Concept 2: Investors are not rational and financial markets are not informationally efficient.

This concept runs directly counter to some of the major conceits of 20th-century finance theory: that investors are expected utility maximizers and market prices reflect all relevant information.

Behavioral economics research decimates the expected utility model. It is virtually impossible for an individual to collect all needed information and then accurately process that information to come up with a rational decision. This is known as bounded rationality, first introduced by economist Herbert Simon.

Even more damaging, Daniel Kahneman, Amos Tversky, and others convincingly demonstrated that even when all information is available, individuals are highly susceptible to cognitive errors. As Kahneman and Tversky concluded after years of research, human beings are typically not rational decision makers.

The very concept of “utility” is flawed. If utility seeks to inject a happiness measure into economic theory, then what aspect of happiness is it gauging: expected, realized, or remembered? Research finds these three to be quite different, even when the same person experiences each. Happiness and, in turn, utility are hopelessly malleable concepts.

Since we are strongly predisposed to make cognitive mistakes due to our emotions, then it takes only a small step to conclude that markets cannot be informationally efficient. The evidence supporting this conclusion is vast: There are hundreds of statistically verified anomalies in the academic literature and more continue to be found.

Implications for Investment Management

A bleak picture of markets emerges: Emotional investors, with their cognitive biases and instinct toward herding, constantly drive prices away from the underlying fundamental value. Unexpectedly, analyzing markets through a behavioral lens provides a more reliable framework. Why? Because individuals rarely change their behaviors. And investing crowds are even less inclined to alter their collective behavior.

Behavioral Concept 3: Investor emotions are the most important determinant of long-horizon wealth in an investment portfolio.

We must consider investor emotions and resultant behavior at every stage of investment management. The process begins with client needs-based planning, in which a separate portfolio is built for each different need. This initial planning phase is critical to removing investor emotions from the wealth-building process.

For the growth portion of the portfolio, the focus is on a long investment horizon. The task of the adviser is to encourage clients to adopt this long-term view while avoiding emotional reactions to short-term events. Evidence indicates that such myopic loss aversion decisions have a profoundly negative effect on wealth. Emotional coaching is one of the most important services an adviser can offer clients.

If needs-based planning is successful, the growth portfolio can be largely invested in high expected return but short-term volatile securities like equities. Admittedly, it is a challenge to keep clients fully invested while avoiding costly trading decisions when markets turn volatile.

Behavioral Price Distortions

When an event like the surprise Brexit vote triggers our emotions, most of us react in a similar way. This collective response is further amplified by herding. Indeed, herding can occur even without an external event. We collectively react because we see everyone else reacting, even though we do not know the reason for the sudden stampede.

Emotional crowds rampaging in the markets create numerous buying opportunities for those who are not caught up in the moment. We refer to these opportunities as behavioral price distortions.

In contrast, these are dubbed “anomalies” in the academic literature because their existence is inconsistent with the efficient market hypothesis (EMH). When they are included in asset pricing models or in constructing smart beta portfolios, they are called “factors.” We prefer the term behavioral price distortions because they are the consequence of collective emotional behavior.

Behavioral Concept 4: Behavioral price distortions are common in financial markets and can be used to build successful investment strategies.

Distortions are the ingredients active managers use when creating an investment strategy. In the case of smart beta, they are the entire strategy. For other active managers, they represent only a portion of the strategy because an investment manager’s “recipe” or decision-making process makes up the rest. Behavioral price distortions are essential to successful active management.

A New World View

Viewing investors and markets as emotional and bad decision makers rather than rational computational entities forces us to reconsider every aspect of investment management. These behavioral concepts provide the framework for rethinking client financial planning, asset allocation, investment manager selection, and the creation and execution of investment strategies.

Shifting to a behavioral perspective is the first step in becoming a behavioral financial analyst. It might seem like a radical step, but really it is just the formal recognition of the obvious. Wisdom is seeing the world for what it is, not what we would prefer it to be.

After recognition comes a formal transition to improved analytic tools, several of which we will highlight in future articles. Such tools are the precursors to The Active Equity Renaissance.

Image credit: ©Getty Images/michelangeloop

Originally published on CFA Institute’s  Enterprising Investor.