May 24

Will Behavioral Portfolio Management Replace the Efficient Frontier?

Tags:

Well, not yet, but after the financial crisis of 2008/09 one must take a long hard look at the use of the famous Markowitz Efficient Frontier and Modern Portfolio Theory (MPT).

At Strategic Asset Alliance, we already do that by using the efficient frontier to suggest possible ‘efficient’ (highest return for given risk) portfolios, but then subject those portfolios to worst case ‘drawdown’ analyses.

Put another way, we like to ask, “If we had chosen this asset allocation in the past, how bad would portfolio valuation have gotten?  And, is that ‘worst case’ an appropriate reduction in value for our insurance company’s portfolio?”   Of course, that last question is subject to numerous caveats and has to be looked at in light of the company’s specific goals, objectives, etc. and, most importantly, the risk appetite of the Board and senior management.

But if MPT isn’t all it is cracked up to be, what will replace it in the canon of investment theory?

How about Behavioral Portfolio Management that uses empirical investigation of investment results to separate the inherent volatility of a given security and volatility tied to investors’ cumulative emotions?

At least that is how C. Thomas Howard looks at it in these two interviews in the CFA Institute’s Enterprising Investor blog here and here.

Howard believes that Behavioral Portfolio Management begins with three basic principles:

  1. Emotional crowds dominate the determination of both prices and volatility, with fundamentals playing a small role.  (A good example, I think, is the way markets overreacted to Chairman Ben’s discussion of tapering US Treasury purchases.)
  2. Thus, price distortions are the rule rather than the exception, making it possible for investors to build superior portfolios.
  3. Volatility and risk are not the same.  It is important to distinguish between short term volatility and the long term nature of many investment portfolios, where volatility is muted by a long term time horizon.  This makes building successful portfolios possible but emotionally difficult, since the investor will nearly always be going against the crowd focused on volatility.  Effectively, this can deprive the investor of the comfort of social validation and require strong emotions to be ignored.

If much of this seems simply another way of discussing contrarian investing, it certainly seems so the more I read through these principles and read through Howard’s latest on Behavioral Portfolio Management.

So, where does this leave your insurance company’s strategic asset allocation decisions?

It is easy to talk about taking advantage of the emotions of other investors.  But, it is very difficult not to be influenced by the crowd (other investors), especially when most of the assets are backing policyholder reserves.  And, one can only hazard a guess at what AM Best would say to a ‘unique’ investment approach, if your firm isn’t run by Warren Buffet, to name one of only a few.

Meanwhile, we must remember that what seems unusual or outlandish today, may become standard operating procedure in the future.  Bonds used to be for coupon clipping instead of actively managing.  Equities used to be traded mostly by institutions and individuals, not high speed computers.

Will Behavioral Portfolio Management (or some variation) be a primary determinant of asset allocation decisions in the future?  Or, will its relevance be successfully challenged?  Such are the challenges of investment management.


For More of the Latest Insurer Investment Insight, please visit InsurerCIO.com