Life after MPT

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Modern portfolio theory (MPT) is questioned by many in the financial advisory industry and for good reason. An ever-growing empirical research stream soundly rejects the three MPT pillars of mean-variance optimization, the capital-asset pricing model (CAPM) and the efficient markets hypothesis (EMH).

On the other hand, 40 years of behavioral science research provides a more realistic framework for viewing investors and markets.

Researchers Daniel Kahneman, the late Amos Tversky, Robert Shiller, Richard Thaler, Hersh Shefrin and Meir Statman, among others, are leading the transition to behavioral finance, as the MPT theories of Harry Markowitz, William Sharpe, and Eugene Fama fade into history.

Contrary evidence piles up

The empirical onslaught against MPT began in the late 1970s. The initial CAPM tests uncovered a negative return to beta relationship (i.e., low-beta stocks performed better than expected). Rather than reject CAPM, however, the discipline responded by searching for statistical problems in those tests. Yet, virtually no evidence supporting the CAPM has been forthcoming.

The EMH first came under attack when Sanjay Basu’s research demonstrated that low-P/E stocks outperformed high-P/E stocks. In the early 1980s, Rolf Banz showed small-cap stocks outperformed large-cap stocks. The problem, of course, is that both P/E and firm size are public information and should not allow investors to earn excess returns. There are now hundreds of empirically verified anomalies.

Proponents argue that the EMH remains viable as long as active equity managers cannot use anomalies to earn excess returns. But for the last 20 years, multiple studies have shown that many active equity managers are superior stock pickers and do indeed earn excess returns on their holdings. Russ Wermers demonstrated that the average stock held by active equity mutual funds earns a 1.3% alpha, and Randolph B. Cohen, Christopher Polk, and Bernhard Silli found that ex-ante best-idea stocks earn a 6% alpha.

In the early 1980s, Robert Shiller argued that almost all volatility observed in the stock market, even on an annual basis, was noise rather than the result of changes in fundamentals. Since EMH held that prices fully reflect all relevant information, volatility driven by anything other than fundamentals strikes at the very heart of the theory.

Shiller’s noisy-market model also created problems for Markowitz’s portfolio optimization. If volatility is the result of emotional crowds, then emotion has been placed in the middle of the portfolio construction process. So rather than being a risk-return optimization, it is an emotion-return optimization

Rejecting the evidence rather than the theory

Much of the leadership in finance pushes aside the mounting contrary evidence and soldiers on under the yoke of MPT. This is surprising. Isn’t finance a discipline based on empiricism, one that only accepts concepts supported by evidence? Unfortunately, as Thomas Kuhn argued years ago in his classic work, The Structure of Scientific Revolutions, scientific and professional organizations are human and are susceptible to the same cognitive errors that afflict individual decision making.

The concepts underlying MPT have not been universally rejected. Instead, they are widely used in studies and show up in textbooks all over the world. MPT’s ubiquity confirms its legitimacy through social validation rather than empirical evidence. Emotional decision making is rampant in what is supposed to be a rational discipline.