Behavioral Investment Management: An Efficient Alternative to Modern Portfolio Theory (PROFESSIONAL FINANCE & INVESTM) - Hardcover

Davies, Greg B.; De Servigny, Arnaud

Hardcover

ISBN 10: 0071746609 ISBN 13: 9780071746601

Publisher: McGraw Hill, 2011

Synopsis

"The main strengths of the book are how methodically the authors trace the history of efficient market pricing…and then show how a more authentic view of markets can be used to one's advantage" Investment Europe, April 2012

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BEHAVIORAL INVESTMENT MANAGEMENT

An Efficient Alternative to Modern Portfolio Theory

By Greg B. Davies, Arnaud de Servigny

The McGraw-Hill Companies, Inc.

Copyright © 2012 The McGraw-Hill Companies, Inc.
All rights reserved.

ISBN: 978-0-07-174660-1

Contents

Introduction
About the Authors
Chapter 1 Questioning the Current Investment Paradigm
Chapter 2 Individual Investor Preferences and Behavior with Peter Brooks 
and Daniel Egan
Chapter 3 Modern Portfolio Theory with Ricardo Feced
Chapter 4 How Well Does Modern Portfolio Theory Work in Practice? with 
Pierre Dangauthier and Prosper Dovonon
Chapter 5 "Behavioralizing" Risk/Return Optimization with Shweta Agarwal
Chapter 6 Representing Asset Return Dynamics in an Uncertain Environment
Chapter 7 Combining Behavioral Preferences with Dynamic Risk/Return 
Expectations
Chapter 8 Portfolio Optimization for the Anxious Investor
Chapter 9 The Impact of Behavioral Investment Management on Wealth and 
Pension Management
Bibliography
Index

Excerpt

CHAPTER 1

QUESTIONING THE CURRENT INVESTMENT PARADIGM

The past 10 years have proved challenging for the asset management industry. Toput it very simply, traditional portfolio-construction procedures have notproduced results capable of consistently outperforming a naive portfolio inwhich all risky assets are equally weighted.

In addition, the claim that in the long term, risky assets and in particularequities should revert to a stable, positive risk premium has been questionedover the last 10 years, a period during which three major troughs have occurred:the technology/Internet crisis between March 2000 and September 2002, which ledto a 45 percent fall in global equity prices, the credit crisis between October2007 and February 2009, which led to a 54 percent drop and the sovereign debtcrisis in 2011. Overall, the period has not been characterized by the benefit ofany long-term positive equity return but rather by extreme spikes of volatility.Investment professionals have lost a lot of respect from their clients, and,more fundamentally, the capability of these professionals to articulate credibleinvestment solutions in response to the crises has been close to nonexistent.

In the opening chapters of this book we will sharpen our diagnosis byidentifying the many weaknesses of the well-established modern portfolio theory(MPT) paradigm, and it is surprising how many flaws and simplisticapproximations it is possible to spot. A positive take on this would be to claimthat a lot of knowledge has been acquired over the past 50 years since MPT, thecapital asset pricing model (CAPM), and the efficient market hypothesis (EMH)were first expounded—now we have to work out how best to apply what wehave learned.

This book is not intended to be a blow-by-blow discussion of technical issues.Instead, we want to take a more fundamental look at the principles of portfoliomanagement, particularly in the light of what has been learned over the past 10years, and to suggest, as a result of our analysis, some possible ways forward.

We believe that any reformulation of portfolio-construction techniques shouldmeet the following four requirements:

1. A clear understanding of the behavior of investors

2. A realistic representation of the dynamics of investment returns

3. A sound and sophisticated blending of these two positions

4. A robust empirical testing framework

In this chapter, and in the three that follow it, we are not going to provide aready-made solution but rather will focus our attention on reasons why thetraditional approaches have not delivered. In Chapters 5 through9 we set out the details of our proposed new approach.

We start here by articulating the link between investors and investments. Wethen focus more specifically on investors and subsequently on investments.

It is important to accompany any theoretical approach to portfolio constructionwith an understanding of what goes on in the real world and of what purposefinancial assets actually serve. In practice, the savings of individuals andinstitutions are invested in a great variety of assets, including both realassets (such as real estate) and financial assets (such as equities and bonds)for the purpose of storing and increasing their stock of wealth. Financialintermediaries reallocate idle resources from savers to those in need ofinvestment to fund profitable projects by transforming, repacking, andredistributing the cash flows generated by the producers, issuing liabilities inexchange. The interaction of many optimizing agents theoretically allowsfinancial markets to reach equilibrium, setting the prices of financial assets.

In terms of understanding the behavior of investors, things are not as simple asthey look. Consider first a specific problem—how we establish a linkbetween the decision-making process of any individual investor and the processby which the community of investors behaves as a whole. The essential insightfrom the discussion of this problem below is that the concept of arepresentative investor (much used in the current financial literature)is largely flawed. This has major implications because it means that slavish useof the MPT/CAPM (see Chapter 2) will produce suboptimal results forindividual investors. This is an unresolved (and usually unremarked) problemthat lies right at the heart of current approaches to investment.

Our third area of focus, which is more of a tour d'horizon related tothe dynamics of investments, highlights the necessity of incorporating differenttime horizons and combining different academic disciplines. We review long-,medium-, and short-term time horizons and outline what economics, MPT, andquantitative analytics, respectively, can tell us about each. All disciplineshave notable weaknesses specific to each of them. We claim that it is essentialto combine the disciplines to form a more realistic picture of the situation.

Investors and Investments

In this section we introduce the main agents in the economy, together with theirtypical portfolios and the assets and liabilities commonly held in their balancesheets. The main agents in an economy can be broadly classified in six groups:

1. Households

2. Corporations

3. Government

4. Retail and commercial banks

5. Other financial intermediaries

6. Central banks

Households

The objective of households is to maximize their consumption and wealth alongtheir life span (and possibly beyond in the case of bequests). Their currentconsumption typically is financed by an annual income together with mortgage andconsumer credit agreements that sit on the liability side of their balancesheets (Table 1.1).

Households store wealth to allow for future consumption by means of a variety ofreal and financial assets. The main real asset is usually property (realestate), but this category may include other valuables, such as cars, jewelry,and art.

Of the financial assets, cash is the safest and most liquid and includescurrency (paper money and coins) and non- (or low-) interest-bearing instant-access deposits at banks (checkable accounts). A broader notion of cash includestime deposits that reward investors with interest for not being able to accesstheir deposits for a stipulated period of time.

Additionally, households typically own government and corporate bonds, publicand private equity, and other funds such as hedge, real estate, and commodityfunds. These financial assets are claims on future cash flows generated by othereconomic agents such as corporations or governments—they correspond toliabilities of other economic agents. Finally, households also hold claims oninsurance and pension benefits.

Corporations

The fundamental objective of corporations is to maximize shareholders' value,measured as the present value of the cash flows generated as a result of theirbusiness activity. The annual performance of a corporation is summarized in itsprofit and loss account, where the earnings from its operations are statedtogether with how these earnings are allocated as payments of interest to thefinance providers, tax to the government, and dividends to shareholders or elseretained by the company for reinvestment.

Corporations have liabilities with respect to their sources of finance(Table 1.2). Bondholders provide firms with capital in exchange forinterest (coupon) payments and repayment of principal at the end of the agreedperiods of time. Shareholders provide capital in exchange for shared ownershipof the corporation, which translates into a stream of periodic dividendpayments.

Prices of corporate bonds reflect the ability of the company to honor itsobligations (credit risk). The two main credit-risk categories areinvestment grade and subinvestment grade (also known asjunk/high yield bonds), with the second type exhibiting higher creditrisk in exchange for higher yields.

Smaller corporations have more difficulty in financing themselves through bondissues and therefore usually rely on bank loans as the source of funds. In thiscase, companies depend on the appetite of banks to lend and on the price atwhich they're prepared to lend. This is related to their required return oncapital, which is itself constrained by the regulatory environment (e.g., theBasel II and Basel III agreements).

Bondholders' and banks' claims on the cash flows of corporations precede thoseof shareholders, making equity a riskier asset class than corporate bonds.Public equity is a more liquid asset class than private equity because it can betraded in secondary markets.

Governments

Governments finance their activities by means of taxes and the issuance of bonds(Table 1.3). Public-sector borrowing requirements depend on thegovernment's ability to match annual tax income with expenditures. Expansivefiscal policies usually give rise to government budget deficits, but these maybe essential to reactivate the economy in periods of recession. However,continuous budget deficits increase a country's national debt, reducingeventually the government's ability to borrow owing to perceived higher creditrisk.

Government bonds can be classified with respect to their maturity (or duration).Long-dated bonds are riskier than short-term bonds in the sense that theirprices will fluctuate over time owing to changes in the general level ofinterest rates (interest-rate risk). If we bought an AAA-rated 10-year-maturitygovernment bond today and sold it in one year, we might incur a loss owing toeither increasing interest rates or a change in credit risk. However, if webought an under-one-year-maturity bond issued by the same government, the mainpossibility of a loss would be related to credit risk.

Government bonds from developed countries (high-grade sovereign bonds)are considered to be the safest assets with regard to credit risk, whereas thosefrom emerging markets (emerging market bonds) are somewhat riskier,although this assessment has to be made on a case-by-case basis, and the gapwith developed markets has been narrowing gradually in recent years.

Retail and Commercial Banks

Retail and commercial banks are financial intermediaries that, in a simplifiedpicture, capture savings in the form of cash deposits or other relatively liquidaccounts (their liabilities) and benefit from lending those funds over longertime horizons (maturity transformation) taking onboard possible creditrisk (Table 1.4). The important role of banks is to intermediate betweenindividuals with spare savings and those in need of funds for consumption orpotentially profitable investments.

Besides cash deposits, banks also fund themselves in the capital markets byissuing long-term bonds or even seeking short-term financing in money markets.The equity owners of the bank earn the yield differential between its assets andits liabilities, which appears in the annual profit and loss account as the netinterest income.

Banks have to keep a given percentage of their clients' deposits (reserveratio) as cash deposits with the central bank (reserves).

The financial health of a bank always has received a high degree of scrutiny.There are two main aspects to monitor. The first is related to the degree ofcredit and market risk on the bank's balance sheet. The second is related to theliquidity mismatch between assets and liabilities resulting from the maturitytransformation operated by the bank. Regulation has primarily focused onproviding safety rules related to the minimum amount of capital to be held bybanks in order to withstand losses resulting from these aforementioned risks.

Central Banks

Central banks are public institutions, usually independent from governments,with responsibility for monetary policy. The central bank directly controls themonetary base of the economy, which includes both the currency in circulationand the banks' reserve accounts with the central bank (Table 1.5).

Other Financial Intermediaries

There are many other financial institutions that act as intermediaries, offeringcustomized financial assets to their clients in exchange for a premium.Intermediaries usually take exposure to a set of risky assets and transformtheir payoff characteristics to adjust the degree of risk of the cash flowsassociated with the financial products sold to their clients (Table1.6).

Insurance companies and pension funds are typical examples of this type offinancial intermediary, where client cash flows are triggered either by aninsured event or by clients reaching retirement age. These institutions investin a variety of assets to be able to hedge their potential liabilities.

Other intermediaries such as mutual funds give small investors access todiversified portfolios that they would not otherwise be able to buy. Structuredproducts repackage the risk of a pool of financial assets, engineering a set oftransformed cash flows that may be able to better match the risk featuresdesired by investors.

The Market Portfolio: Consolidated Private and Institutional Investors

In preceding sections we described the balance sheets held by the various agentsin the economy. Let us focus now on the consolidated portfolios of private andinstitutional investors—mainly households and some financialintermediaries such as pension funds and insurers. Their consolidated assets andliabilities are summarized in Table 1.7.

In the balance sheet, we observe two main components:

1. A long or short position in the riskless asset. Banks allow privateand institutional investors to establish the desired level of cash or debt(leverage) in their investment portfolios.

2. A variety of risky real and financial assets. Private andinstitutional investors absorb the issues of financial assets by governments andcorporations in the primary capital markets and will further trade them insecondary markets. They also invest in other financial assets, such assecuritized credit or hedge funds, which can be thought of as assets repackagedby financial intermediaries.

It is important to have in mind this systematic approach of economicintermediaries operating in a partial-equilibrium setup. Analogous to what takesplace in physics with the principle of connected vessels, the demand for and theprice of assets depend directly on the relative appetite for them by private andinstitutional investors. This balance is referred to in macroeconomics as thebudget constraint. This constraint is not soft but is binding.Disequilibria may lead to a breaking of a constraint and, as a result, toserious crises.

Zooming In on the Microeconomic Investor

In the preceding we showed that even at a macroeconomic level, we cannot easilytalk about a single investor. Investors can be households, corporations,governments, commercial banks, and central banks. Each of these investor types,and individual entities of each type, may have very different preferences andvery different amounts of capital to deploy. In this section we focus ondisentangling the unclear links assumed between the microeconomic preferences ofindividual investors and the overall macroeconomic behavior of the market.

In MPT, as well as in the CAPM, there are a few key elements that guide theconstruction of an optimal portfolio for any investor. First, there exists a setof particular combinations of all assets that offers optimal returns for anygiven level of risk. Second, depending on their risk tolerance, all investorsshould hold a combination of a single one of these optimal portfolios and cash(or leverage for highly risk-tolerant individuals).

However, this neat solution where all investors simply hold an appropriateportion of their total wealth in a single, well-defined portfolio dependsheavily on a very strong assumption—that there exists a representativeinvestor who is a single market agent that represents the aggregated beliefsand preferences of all investors in the market combined. Without this, therewill be no clear way of aggregating either the beliefs about future risks andreturns of multiple market participants or their preferences (degrees of riskaversion). Risk aversion helps us to define the attitude of an investor facedwith investments, the financial outcomes of which are uncertain. It defines howmuch uncertainty is tolerable in any risk/return tradeoff and thus determinesthe marginal price of risk. It would be very useful if a representative investordid exist because then there would be a direct relationship between establishingthe optimal portfolio allocation for any individual and for that of the marketas a whole in equilibrium. Without this representative investor, there is nosimple notion of equilibrium to which the market can converge to represent therisk/return preferences of market participants.

The Elusive Representative Investor

While this concept of a representative investor sounds useful enough, it isimportant to think carefully about what exactly happens when we try to aggregatedifferent beliefs and different risk-tolerance levels to create this beast.

Problems with Preferences

In equilibrium, the expected return of each asset will adjust according to thelaws of demand and supply—the supply fixed by the amount of the assetavailable and the demand by the price the representative investor will pay givenits risk. Assets with overly high expected returns relative to their risk willincrease in price, reducing the expected returns, and the opposite will happenfor those with low expected returns relative to their expected risk. All assetswill adjust so that marginal demand equals marginal supply.

The notion of a representative investor simplifies this progress towardequilibrium because we can represent the combined preferences of all marketparticipants in the preferences of a single individual, who becomes the marginalinvestor for all assets. Without this, we have no way of representing themarginal investor and thus no way of determining the expected returns of eachasset.

(Continues...)

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Excerpted from BEHAVIORAL INVESTMENT MANAGEMENT by Greg B. Davies, Arnaud de Servigny. Copyright © 2012 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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Edition details

• Publisher: McGraw Hill
• Publication date: 2011
• ISBN 10: 0071746609
• ISBN 13: 9780071746601
• Binding: Hardcover
• Language: English
• Number of pages: 400