{"id":29256,"date":"2023-06-29T15:15:55","date_gmt":"2023-06-29T19:15:55","guid":{"rendered":"https:\/\/ifintechworld.com\/markets\/harry-markowitzs-ideas-are-critically-reshaping-financial-services-even-now\/"},"modified":"2023-06-29T15:15:57","modified_gmt":"2023-06-29T19:15:57","slug":"harry-markowitzs-ideas-are-critically-reshaping-financial-services-even-now","status":"publish","type":"post","link":"https:\/\/ifintechworld.com\/?p=29256","title":{"rendered":"Harry Markowitz\u2019s Ideas Are Critically Reshaping Financial Services, Even Now"},"content":{"rendered":"
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Now is a very good time to reflect on how Harry Markowitz\u2019s ideas are critically reshaping financial services. Although Markowitz just passed away at age 95, his ideas continue to change the way people invest; and some of those ideas are behavioral.<\/p>\n

Yes, behavioral! A lot of readers will be surprised to learn that Markowitz described himself as \u201cthe grandfather of behavioral finance.\u201d I know. I was present when he said it, and will share my reflections in this post.<\/p>\n

Markowitz\u2019s behavioral ideas focus on how investors actually behave. In contrast, the non-behavioral ideas for which he is best known focus on how investors ought to behave. In the main, there is a huge gap between the two behaviors; and the future of financial services will focus on filling this gap.<\/p>\n

Amazingly, Markowitz published both of his key ideas in the same year, 1952. The work for which he was honored with a Nobel prize pertains to Modern Portfolio Theory. MPT is a rigorous approach for selecting well-diversified portfolios which balance expected return against risk.<\/p>\n

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Markowitz\u2019s behavioral work pertains to investors\u2019 tendency to hold both very safe and very risky investments. This duality had already been the subject of study at the University of Chicago, where Markowitz was pursuing his PhD. Notably, Markowitz\u2019s key contribution was to identify the key role of an investor\u2019s \u201ccustomary wealth.\u201d Ultimately this innovation would lead to the concept known as \u201cgoal-based investing.\u201d<\/p>\n

I first became aware of Markowitz\u2019s behavioral work in the early 1980s. At the time, my colleague Meir Statman and I became the first economists to apply the revolutionary framework known as \u201cprospect theory\u201d to financial decision making. One of our journal editors pointed to Markowitz\u2019s behavioral work. This was because Daniel Kahneman and Amos Tversky, the psychologists who developed prospect theory, built their framework using Markowitz\u2019s insights.<\/p>\n

Research in behavioral finance exploded over the next two decades. In 2000 I edited a collection of behavioral writings, and included Markowitz\u2019s behavioral paper from 1952. When the collection was published, Markowitz was kind enough to let me how happy he was to have his paper in the collection.<\/p>\n

Over a decade later, Markowitz was being interviewed at a conference hosted by the Journal of Investment Management<\/em>. I was in the audience for the interview. The interviewer asked Markowitz whether he regarded himself as the father of behavioral finance. The audience chuckled at the question, as most of them thought of Markowitz in connection with MPT. Markowitz also chuckled. But then he replied that he thought of himself as the \u201cgrandfather of behavioral finance.\u201d And after uttering the phrase, he turned to me in the audience and exclaimed, \u201cisn\u2019t that right, Hersh?\u201d<\/p>\n

In truth, behavioral finance goes back many generations. Adam Smith, John Maynard Keynes, Hyman Minsky, and Herbert Simon all qualify as behavioral economists, for having incorporated explicit psychological concepts into their analyses. Markowitz clearly saw himself in this company; and yet it seems clear that it was MPT which provided the lens through which he viewed the investment world. Meir Statman describes his two 1952 papers as twins, with Markowitz clearly favoring one of his children over the other.<\/p>\n

MPT has a behavioral counterpart, known as behavioral portfolio theory, which Statman and I developed. BPT explains how investors select portfolios to satisfy psychological needs associated with downside protection, upside potential, and the achievement of financial goals. Typically, portfolios formed in accordance with BPT are not well-diversified. Instead, they are formed by mixing very safe and very risky securities; and some of the risky securities are lottery-type stocks. Not surprisingly, this feature ties back to Markowitz\u2019s behavioral work.<\/p>\n

The fact is that most individual investors do not hold portfolios which remotely conform to MPT. Let me make this point a bit differently. MPT does not describe how most individual investors behave. Indeed, there is huge variation in the performance of individual investors\u2019 portfolios, reflecting the impact of concentration and lottery type securities, not diversification.<\/p>\n

In theory, portfolios formed in accordance with MPT enable investors to be efficient when they balance expected risk and return. However, in its pure form, even the theory underlying MPT produces portfolios which do not conform to our intuition about what diversification entails. This divergence has led to the addition of heuristic maneuvers to make MPT generate portfolios which are intuitively appealing. Still, most individual investors hold portfolios which exhibit BPT features which are mean-variance inefficient.<\/p>\n

After BPT was published, I was struck when Markowitz wrote me to say that he was uncomfortable with behavioral portfolios being mean-variance inefficient. I think what made him uncomfortable is the suggestion that individual investors might not want to hold portfolios constructed in accordance with MPT. For Markowitz, and many others in the financial services industry, the challenge has been how to induce individual investors to hold mean-variance efficient portfolios.<\/p>\n

Markowitz wrote an interesting paper in which he attempted to square this circle. The paper is written with my colleagues Sanjiv Das, Jonathan Scheid, and Meir Statman. Markowitz and his co-authors provides a mental accounting framework in which investors balance their needs to attain a series of goals. The associated portfolios square the circle in that they address behavioral needs while being mean-variance efficient. That said, the approach only uses securities with normally distributed returns, which excludes most lottery-type stocks; and many investors have a need to hold lottery-type stocks.<\/p>\n

One of the most dramatic changes to the investment landscape is investors\u2019 focus on ESG. ESG-investing addresses needs akin to the need for security, potential, and success. The thing is that ESG-tilts by their nature tend to induce mean-variance inefficiency. Many investors appear willing to sacrifice a degree of diversification in exchange for increased exposure to ESG attributes. This feature mirrors the message from BPT that many investors are willing to sacrifice a degree of diversification in order to satisfy particular psychological needs and wants.<\/p>\n

The current reshaping of the financial services industry reflects both Markowitz contributions, MPT and behavioral. The industry will serve investors well by putting both of those contributions into practice. Investors largely want their portfolios to satisfy psychological needs, and the industry can develop solutions which enable them to do so. By incorporating key principles from MPT, the industry can develop solutions which are efficient. Accomplishing both tasks will provide Markowitz with a great legacy, much more important than if it were based on MPT alone.<\/p>\n<\/div>\n

Read the full article here<\/a><\/p>\n","protected":false},"excerpt":{"rendered":"

Now is a very good time to reflect on how Harry Markowitz\u2019s ideas are critically reshaping financial services. Although Markowitz just passed away at age 95, his ideas continue to change the way people invest; and some of those ideas are behavioral. Yes, behavioral! A lot of readers will be surprised to learn that Markowitz […]<\/p>\n","protected":false},"author":1,"featured_media":29257,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[241],"tags":[83],"class_list":["post-29256","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-markets","tag-featured"],"yoast_head":"\nHarry Markowitz\u2019s Ideas Are Critically Reshaping Financial Services, Even Now | iFintechWorld<\/title>\n<meta name=\"description\" content=\"Now is a very good time to reflect on how Harry Markowitz\u2019s ideas are critically reshaping financial services. 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