«What is too simple results wrong,
what is too realistic is useless».
Paul Valéry
Why should we question modern portfolio theory?
In the 80’s what was called “Modern portfolio theory” clearly reached its peak. This approach is essentially based on the concepts of:
- the individual’s rationality
- independence between individuals
- markets efficiency
However, in the investors’ real world, things turn out not to happen the way classical models would like to explain it.
Excess of confidence, underestimation of extreme events probabilities, difficulty in reckoning losses, weak portfolios diversification, mimetism, perception mistakes, these are nothing but demonstrations of the human behaviour towards Financial Markets and changes in portfolios values.
As a result, investing doesn’t rely on a pure rational decision, which is based on the sole analysis of the “fundamentals”, such as interest rates, profits, monetary aggregates or risk premium level. Market players are not always rational and markets are not efficient, insofar as price levels don’t always reflect the available information.
Behavioural Finance enriches the classical model and enables investors to better understand financial markets.