Behavorial Finance vs. Portfolio Theory: Is the Rational Investor Dead?

Abstract

Quite a heated debate has been raging in Finance Theory since the early 1990’s regarding the relevance of Modern Portfolio Theory. Yet both adversaries are overlooking something very fundamental that could in fact bring them much closer. My working paper on the Market Indifference Curve provides this missing link: it allows for the integration of what investors refer to as ‘sentiment’ in the efficient pricing of risk by rational investors.Specifically, it demonstrates that (even) in the context of rational investors, the fair price of total risk at any time t reflects the aggregate – not absolute or unanimous! – risk aversion among investors at that time. If only anecdotic, intuitively such interpretation corresponds closely to what we observe when monitoring spread risk: the continuous consensual pricing of the risk premium by investors. When next, as Behavioral Finance proscribes, ‘non-rational’ behavior such as excessive optimism and excessive pessimism enters the equation, periods of substantial consensual mispricing of risk (herd behavior) may occur indeed, yet still based on the same premise: the efficient market reflects the consensus price of risk. In sum, the rational investor is alive and kicking and in principle at any time t the market efficiently provides the fair consensual price of risk. However, irrespective of whether investors are rational or not, this fair price of risk – a time sensitive consensual phenomenon by default – should be distinguished from the (incorrect) notion of an unanimous or absolute price of risk.