Behavioural Portfolio Theory

Behavioural portfolio theory, introduced by Shefrin and Statman (2000), is a goal based
theory. In that theory, investors divide their money into many mental account layers of a
portfolio pyramid corresponding to goals such as having a secure retirement, paying for
a college education, or being rich enough to hop on a cruise ship whenever they please.

A central feature in behavioural portfolio theory is the observation that investors view their
portfolios not as a whole, as prescribed by mean-variance portfolio theory, but as distinct
mental account layers in a pyramid of assets, where mental account layers are associated
with particular goals and where attitudes toward risk vary across layers. One mental
account layer might be a “downside protection” layer, designed to protect investors from
being poor.

Another might be an “upside potential” layer, designed to give investors a chance at being
rich. Investors might behave as if they hate risk in the downside protection layer, while they
behave as if they love risk in the upside potential layer. These are normal, familiar investors,
investors who are animated by aspirations, not attitudes toward risk.

Behavioural Asset Pricing Model

Stripped to their basics, all asset pricing models are versions of the old reliable supply-and-
demand model of introductory economics.
The benefits that determine demand of a product vary from product to product, but they
can be classified into three groups: utilitarian, expressive, and emotional. The utilitarian
benefits of a car include good gas mileage and reliability. Expressive benefits are those that
enable us to signal to ourselves or others our values, social class, and tastes.
Expressive characteristics include style (e.g., the style of a Jaguar) and social responsibility
(e.g., the environmental responsibility of a Prius). Emotional benefits include pride (e.g.,
“having arrived” with a Rolls Royce) and exhilaration (e.g., BMW as the “ultimate driving
machine”).
In the investment context, utilitarian benefits are often labelled “fundamental,” and
expressive and emotional benefits are often labelled “sentiment.”

High expected returns and low risk are utilitarian benefits of a stock, and those who
restrict the demand function to it are considered rational. The rubric of rationality is not so
easily extended to expressive and emotional benefits, such as the display of social
responsibility in a socially responsible mutual fund, the display of wealth in a hedge fund, or
the excitement of an initial public offering.

So investors buy stocks not only based on the expected return of a stock or asset rather they
have fundamental and sentimental reasons to buy a stock. Unlike CAPM which advocates
that people choose financial assets based on expected return and the beta is the major
measure of the expected return.

Feature CAPM Behavioural Asset Pricing Model

 (BAPM)
Investor Allows for irrationality and
Assumes fully rational investors
Rationality psychological biases
Market Markets can be inefficient due to
Markets are efficient
Efficiency investor sentiment
Risk Risk is measured by beta Incorporates both fundamentals and
Measurement (systematic risk) sentiment risk
Investors may have heterogeneous
Expectations Homogeneous expectations
beliefs
Explanation Both risk and sentiment (irrational
Only systematic risk matters
of Returns forces) affect returns
Beta’s Role Central to pricing Still used but not sufficient alone
Explicitly models investor
Emotional
Ignored sentiment, overreaction,
Factors
underreaction
Information Info may be misinterpreted or
Perfect and complete info
Use ignored due to bias
Real-world Better at explaining anomalies like
Simple but often inaccurate
Performance momentum, bubbles
More complex and harder to
Ease of Use Simple and widely taught
quantify sentiment
Empirical Increasing support due to observed
Mixed results
Support market anomalies

What Is Adaptive Market Hypothesis (AMH)?

The adaptive market hypothesis (AMH) is an alternative economic theory that combines
principles of the well-known and often controversial efficient market
hypothesis (EMH) with behavioural finance. It was introduced to the world in 2004
by Massachusetts Institute of Technology (MIT) professor Andrew Lo.

Understanding the Adaptive Market Hypothesis (AMH)

The AMH attempts to marry the theory posited by the EMH that markets are rational and
efficient with the argument made by behavioural economists that they are actually irrational
and inefficient.

For years, the EMH has been the dominant theory. The strictest version of the EMH states
that it is not possible to "beat the market" because companies always trade at their fair
value, making it impossible to buy undervalued stocks or sell them at exaggerated prices.

behavioural finance emerged later to challenge this notion, pointing out that investors
were not always rational and stocks did not always trade at their fair value during
financial bubbles, crashes, and crises. Economists in this field attempt to explain stock
market anomalies through psychology-based theories.

The AMH considers both these conflicting views as a means of explaining investor and
market behaviour. It contends that rationality and irrationality coexist, applying the
principles of evolution and behaviour to financial interactions.
How the Adaptive Market Hypothesis (AMH) Works

Lo, the theory’s founder, believes that people are mainly rational, but sometimes can
quickly become irrational in response to heightened market volatility. This can open up
buying opportunities. He postulates that investor behaviours—such as loss aversion,
overconfidence, and overreaction—are consistent with evolutionary models of human
behaviour, which include actions such as competition, adaptation, and natural selection.1

people, he added, often learn from their mistakes and make predictions about the future
based on past experiences. Lo's theory states that humans make best guesses based on trial
and error. This means that, if an investor's strategy fails, they are likely to take a different
approach the next time. Alternatively, if the strategy succeeds, the investor is likely to try it
again.

The AMH is based on the following basic tenets:

1. People are motivated by their own self-interests

2. They naturally make mistakes
3. They adapt and learn from these mistakes

The AMH argues that investors are mostly, but not perfectly, rational. They engage in
satisficing behaviour rather than maximizing behaviour, and develop heuristics for
market behaviour based on a kind of natural selection mechanism in markets (profit and
loss). This leads markets to behave mostly rationally, similar to the EMH, under conditions
where those heuristics apply.

However, when major shifts or economic shocks happen, the evolutionary environment of
the market changes; those heuristics that were adaptive can become maladaptive. This means
that under periods of rapid change, stress, or abnormal conditions, the EMH may not hold.

Examples of the Adaptive Market Hypothesis (AMH)

Suppose there is an investor buying near the top of a bubble because they had first
developed portfolio management skills during an extended bull market. While the reasons
for doing this might appear compelling, it might not be the best strategy to execute in that
particular environment.

During the housing bubble, people leveraged up and purchased assets, assuming that
price mean reversion wasn't a possibility (simply because it hadn't occurred recently).
Eventually, the cycle turned, the bubble burst and prices fell.

Adjusting expectations of future behaviour based on recent past behaviour is said to be a

typical flaw of investors.

Criticism of Adaptive Market Hypothesis (AMH)

Academics have been sceptical about AMH, complaining about its lack of mathematical
models. The AMH effectively just echoes the earlier theory of adaptive expectations in
macroeconomics, which fell out of favour during the 1970s, as market participants were
observed to most form rational expectations. The AMH is essentially a step back from
rational expectations theory, based on the insights gained from behavioural economics.

Systematic Underperformance

Definition:
Systematic underperformance refers to the consistent inability of an investment strategy,
asset class, or portfolio manager to outperform a benchmark (like the S&P 500, NSE 500
or a market index) over time, even after adjusting for risk.

Key Points:

 Benchmarking: Performance is often measured against a benchmark. If a fund

consistently earns less than its benchmark, it's said to systematically underperform.
 Persistence: This underperformance is not random—it shows a pattern over time,
which indicates structural issues in the strategy.
 Common Causes:
o High Fees: Actively managed funds often charge higher fees than passive
ones, which eat into returns.
o Inefficiency: Trying to beat the market requires superior information or skill.
Many managers lack this consistently.
o Overtrading: Frequent buying/selling increases transaction costs and taxes,
hurting returns.
o Herding behaviour: Managers may mimic popular trends rather than use
independent judgment, diluting potential alpha.
 Empirical Evidence:
o Numerous studies (e.g., SPIVA reports) show that a majority of actively
managed funds underperform their benchmarks over long time horizons.
o For example, over a 10-year period, more than 85% of U.S. large-cap active
funds underperform the S&P 500.

Active Portfolio Management and Alpha Hunting

Definition:
Active portfolio management involves making specific investments with the goal of
outperforming an investment benchmark index. “Alpha hunting” is the pursuit of excess
returns above that benchmark (i.e., generating "alpha").

Key Concepts:

 Alpha (α):
The excess return of an investment relative to the return of a benchmark index. If a
fund returns 10% and its benchmark returns 8%, alpha is +2%.
 Active Management Techniques:
o Stock Picking: Selecting undervalued or overvalued stocks to generate
returns.
o Market Timing: Adjusting portfolio exposure based on predictions of market
movements.
o Sector Rotation: Allocating assets to sectors expected to outperform.
 Tools for Alpha Hunting:
o Fundamental Analysis: Examining financial statements, industry conditions,
and macroeconomic indicators.
o Technical Analysis: Analysing price charts and trading volumes.
o Quantitative Models: Using algorithms and statistical models to find
opportunities.
 Challenges in Alpha Hunting:
o Efficient Market Hypothesis (EMH): If markets are truly efficient, all
available information is already priced in, making alpha hunting nearly
impossible.
o Skill vs. Luck: It's hard to differentiate skilful managers from lucky ones over
short periods.
o Costs: Research, analytics, and trading costs reduce net alpha.
 Trends:
o Many investors are shifting to passive investing (e.g., index funds, ETFs) due
to consistent underperformance of active strategies.

3. Socio-Psychological Challenges to Financial Markets

Definition:
These refer to the cognitive, emotional, and social factors that influence investors' behaviour,
often leading to irrational decision-making and market anomalies.

3.1 Key Behavioural Finance Concepts:

 Cognitive Biases:
o Overconfidence: Investors overestimate their knowledge or ability to predict
market movements.
o Anchoring: Relying too heavily on the first piece of information (like a
stock’s past high) when making decisions.
o Loss Aversion: Fear of loss outweighs the pleasure of gains, leading to
suboptimal decisions (e.g., holding losers too long).
o Confirmation Bias: Looking for information that confirms one’s beliefs while
ignoring contradictory data.
  Emotional Factors:
o Fear and Greed: Extreme emotions can lead to bubbles (excessive optimism)
or crashes (panic selling).
o Herding Behaviour: Tendency to follow the crowd, often against one's own
judgment, especially in speculative manias.
 Social Influences:
o Media Influence: Sensational news can amplify market movements.
o Groupthink: In institutions, consensus thinking can prevent innovative or
contrarian ideas from being explored.
 Market Impacts:
o Bubbles and Crashes: These are often driven more by psychology than
fundamentals (e.g., Dot-com bubble, 2008 crisis).
o Inefficient Pricing: Assets may be mispriced due to irrational behaviour,
creating opportunities or risks.

Implications:

 Markets are not always efficient because they are driven by human behaviour.
 Behavioural finance seeks to integrate psychological insights with traditional financial
models.
 Recognizing these biases can help investors make more rational decisions or design
better financial products (e.g., nudges in retirement planning).

3.2Market Anomalies
Socio-psychological Factors can affect the financial markets in the form of market
anomalies

Definition:

Market anomalies are patterns in stock returns or pricing behaviours that deviate from
what standard financial theories (like the Efficient Market Hypothesis) would predict. In
simple terms, these are irregularities or predictable patterns in financial markets that
should not exist if markets were perfectly rational and efficient.

Why Are Market Anomalies Important?

 They challenge the idea that markets are perfectly efficient.

 They offer potential opportunities for investors to earn abnormal returns (also called
alpha).
 They help us understand investor psychology, behavioural biases, and market
inefficiencies.
Types of Market Anomalies
1. Calendar Anomalies

These are patterns in stock returns based on the time of year, month, or day.

Examples:

 January Effect: Small-cap stocks often perform better in January. This is believed to
be due to tax-loss selling in December and reinvestment in January.
 Day of the Week Effect: Returns on Mondays are often lower than other weekdays
(known as the “Monday effect”).
 Turn-of-the-Month Effect: Stocks often rise in the last few days of a month and the
first few days of the next.

2. Fundamental Anomalies

These involve deviations from valuation models like the Capital Asset Pricing Model
(CAPM) or traditional financial metrics.

Examples:

 Value Effect: Stocks with low price-to-earnings (P/E) or price-to-book (P/B) ratios
often outperform high P/E or growth stocks.
 Size Effect: Smaller companies (small-cap stocks) tend to earn higher risk-adjusted
returns than larger companies.
 Earnings Momentum: Stocks that have recently reported good earnings often
continue to perform well for a period.

3. Technical Anomalies

These are based on price and volume patterns, contrary to the belief that past prices can’t
predict future movements.

Examples:

 Momentum Effect: Stocks that have been rising tend to keep rising for a while (and
vice versa for losers).
 Reversal Effect: Over longer periods, extreme winners or losers tend to reverse, i.e.,
losers may become winners and vice versa.

4. Behavioural Anomalies

These stem from psychological biases and irrational behaviour of investors.

Examples:

 Overreaction: Investors overreact to bad or good news, pushing prices too far in one
direction.
 Underreaction: Sometimes, markets are slow to react to news, creating delayed price
adjustments.
 Herding Behaviour: Investors follow the crowd, buying popular stocks regardless of
fundamentals.

5. Market Microstructure Anomalies

These relate to trading mechanics and market structure.

Examples:

 Liquidity Effect: Less liquid stocks often offer higher expected returns to
compensate for the risk of illiquidity.
 Bid-Ask Bounce: Price fluctuations due to the spread between buying and selling
prices can create apparent anomalies in returns.

Implications of Market Anomalies

Implication What It Means
Challenges EMH Suggests that markets are not always efficient and rational
Opportunity for active
May present chances to generate alpha or abnormal returns
managers
Linked to behavioural Often caused by human psychology and biases (fear, greed,
finance overconfidence, etc.)
Often short-lived Once discovered, anomalies may disappear due to arbitrage
Conclusion:
Market anomalies highlight imperfections in financial markets that contradict traditional
economic theory. While some anomalies persist, others vanish as markets adapt. Investors,
researchers, and fund managers study these to understand behaviour, develop strategies, or
challenge existing financial models.