Behavioral Portfolio Management. C. Thomas Howard
to act, then economics is how they actually act. In their view, incentives are the cornerstone of modern economic life and to understand why people or organizations do what they do, you need to understand the incentives driving them. This turns out to be incredibly important for understanding financial markets and, in particular, the institutions that have grown up around these markets.
Reluctantly rejecting MPT
I received my PhD in 1978 at what I now realize was the peak of Modern Portfolio Theory (MPT). Having a strong quant background, I was thrilled to see firsthand the launch of a simple, concise theory of capital market equilibrium. The rational behavior model, first proposed by Bernoulli in 1738, had become the standard within the social sciences and now, with the emergence of MPT, it was being placed at the very heart of finance.
But quickly it became apparent that MPT was not living up to its advanced billing. As I graduated, the small firm effect was being reported by Banz and the low PE effect was being reported by Basu. These two anomalies simultaneously challenged the Efficient Market Hypothesis (EMH) as well as the Capital Asset Pricing Model (CAPM), two pillars of MPT. Since then it has only gotten worse, with the CAPM now thoroughly discredited and the EMH riddled with gaping holes.
What is more, I now realize that the third pillar of MPT is built on emotionally-driven market volatility. That is, mean-variance optimization places emotions at the center of portfolio construction. Thus it is surprising to discover that, by focusing on volatility in building long-term portfolios, both emotions and returns are reduced while risk is increased. By using what is one of the most widely accepted portfolio models (its creator was awarded an Economics Nobel Prize in 1990), you are actually succumbing to the Crowd.
As my career progressed, the growing body of empirical evidence has led me to reject MPT in its entirety. In the spirit of Levitt and Dubner, I found conventional wisdom in the form of MPT to be wrong. The underlying data point to a much different reality – that is behavioral finance in which investors make emotional rather than rational decisions. In a variation on Levitt and Dubner’s economics versus morality observation, it turns out that if MPT is the way investors ought to act, behavioral finance is the way they act in reality. Thus I concluded, with some nostalgia for the less messy way of viewing financial markets, that building portfolios based on MPT concepts is hazardous to your wealth. I view BPM as an alternative to MPT.
A personal journey
The material presented in this book is as much a personal journey as it is a professional one. I talk about releasing the emotional brakes that prevent us from building successful portfolios. You can have the best investment strategy, but if your emotional brakes are set, then you will ultimately fail.
My personal journey within – as they say, the scariest journey of them all – began about 25 years ago. During my 20s and 30s I kept saying to myself there were personal issues I needed to think about, but I was too busy with family and career, so put off this effort. But when I reached my 40th birthday I began this journey, the actual trigger for which is lost in the haze of time.
One of the books I read at the time was particularly influential: Scott Peck’s The Road Less Traveled. It turns out that I’ve taken that road less traveled in thinking about investment decisions, as well as a range of other matters. With the help of 20/20 hindsight, I realize that I could not have made the professional journey that produced Behavioral Portfolio Management without also making the personal journey. As a result, I have been able to release many of the emotional brakes that I will discuss in the early part of this book, allowing me to build successful portfolios based on BPM concepts. In its own right, BPM is a road less traveled.
Lest I should be appearing to suggest I have completely mastered my emotions, let me confess to one of my emotional failures. I suffer from acrophobia, an unreasonable fear of heights. Take me up in a tall building and put me in front of a large window and I dissolve into an irrational panic, at times having difficulty even standing.
Twice my wife and I have gone up the Eiffel Tower. We took the elevator to the second level and she continued to the third level alone, leaving me trembling on the second level, unable to bring myself to take what I was convinced was the perilous journey to the third level. Twice she wrote our names on the wall on the third level without me, which took a little romance out of the Parisian experience. My acrophobia is a constant reminder of the challenge one faces when trying to master emotions; don’t expect it to be easy.
About this book
Two threads run throughout Behavioral Portfolio Management. First, conventional wisdom regarding the markets and how to invest in them is often wrong. As Einstein said, “Common sense is nothing but a collection of misconceptions acquired by age eighteen.” As I will argue, common sense and conventional wisdom rarely lead to good investment decisions.
Second, to discover what works requires the careful analysis of large data sets over extended time periods. This kind of diligent effort is essential to uncovering those factors important for building successful portfolios. Put another way, what Daniel Kahneman calls System 1 thinking – dependence on anecdotal information and virtually automatic decision-making – is a sure route to underperformance. To be successful, it is important to turn on your slow and deliberate System 2 in order to tease out those behavioral factors critical to building successful portfolios.
As is frequently the case when discussing new ways of thinking about the world around us, it is easier to describe the final outcome than the process one needs to follow to get there. Most of the book is focused on a new way to think about financial markets and creative ways to build portfolios based on behavioral factors.
I will provide aids to help understand how to implement BPM. First, wherever possible I will provide practical suggestions on how to implement such things as releasing your own emotional brakes, as well as the emotional brakes of your clients. Much is being written about these processes and so I expect that you will have a number of suggestions available to you beyond this book.
Second, I will summarize the research underlying the transition from MPT to behavioral finance and then on to BPM so that you will not need to trace this journey for yourself by spending a great deal of time reading dense academic papers. For those who want to dig in further, I provide a comprehensive bibliography of the underlying BPM research at the end of the book.
This book is based on my 35 years in teaching, research, and actual portfolio management. I hope you find what I present useful in building a successful portfolio. And, finally, I leave you with the investor’s blessing: may you always buy low and sell high (or at least 60% of the time)!
C. Thomas Howard, Denver, Colorado, 2014
Acknowledgements
In building the case for BPM, I frequently reference three books: Daniel Kahneman’s Thinking, Fast and Slow, Nassim Taleb’s Fooled by Randomness, and Hersh Shefrin’s Behavioralizing Finance.
Kahneman, winner of the 2002 Nobel Memorial Prize in Economic Sciences, does a masterful job of presenting the major conclusions of Behavioral Science, providing numerous insights into how individuals actually make decisions using shortcuts and heuristics. The rational model it is not. Behavioral science came of age during the same time period over which MPT became the de facto standard in the investment management industry. I came to wish my own education and early experience would have included much more behavioral science and much less MPT, but it is better to be late than never as they say.
Taleb provides an eminently readable exposition on the challenge facing individuals in mastering one of the most difficult realties of the world: the random nature of events and markets. He contends that the complex and random nature of the investing world we face has outrun our brains’ evolutionary hard wiring. To be successful, an investor must think of the world in terms of probabilities and previously unobserved dramatic events (black swans in his parlance). This requires a dose of heavy-duty analytic thinking – what Kahneman refers to as