Practical analysis for investment professionals
08 May 2017

The Active Equity Renaissance: Behavioral Financial Markets

We have questioned many orthodoxies of modern portfolio theory (MPT) in this series, challenging currently accepted models of financial markets and exploring the decline of MPT and the folly of using volatility as a measure of investment risk.

But in undermining the foundations of MPT, what do we propose to take its place?

Behavioral Finance Is a More Promising Alternative

It is time to move away from MPT to a more promising alternative: behavioral finance. The analytical tools derived from behavioral finance’s more realistic representation of financial markets and human behavior will likely replace the wealth-limiting MPT tools in use today. Sadly these same outdated and ineffective MPT tools help select and evaluate active equity managers. Abandoning such obsolete instruments is critical to ushering in The Active Equity Renaissance.

A fully developed behavioral model of financial markets does not yet exist, but several underlying concepts and their resultant implications for investment management are emerging.

A Prospective Investment Framework

Financial markets are populated by human investors burdened with emotional baggage and associated cognitive errors. In a market context, these errors are amplified because, in the aggregate, they create herding, which leads to wild price swings. Rampaging emotional crowds cause extreme volatility of returns in financial markets. Look no further than equity market price bubbles for evidence of these rampaging emotions.

Behavioral Concept 1: Emotional crowds, not fundamental changes, drive price movements in financial markets.

Financial markets cannot be neatly packed into a set of mathematical equations. Markets are messy, and the only way to make sense of them is to view them in all their disorder.

We will never understand why markets and their underlying securities move the way they do over shorter time periods. So if we’re asked why the market, a stock, or other security moved the way it did on a particular day, the honest answer is almost always, “I have no idea.” In fact, research demonstrates that only a minute percentage of the market transacts on any given day. Yet, investors and investment journalists always ascribe a rationale to market movements even when the implied causality is chimerical. Unsettling as this may be, it is an effect of our first behavioral concept: Emotions — not fundamentals — are the main movers of financial markets.

Behavioral Concept 2: Investors are not rational and financial markets are not informationally efficient.

This concept runs directly counter to some of the major conceits of 20th-century finance theory: that investors are expected utility maximizers and market prices reflect all relevant information.

Behavioral economics research decimates the expected utility model. It is virtually impossible for an individual to collect all needed information and then accurately process that information to come up with a rational decision. This is known as bounded rationality, first introduced by economist Herbert Simon.

Even more damaging, Daniel Kahneman, Amos Tversky, and others convincingly demonstrated that even when all information is available, individuals are highly susceptible to cognitive errors. As Kahneman and Tversky concluded after years of research, human beings are typically not rational decision makers.

The very concept of “utility” is flawed. If utility seeks to inject a happiness measure into economic theory, then what aspect of happiness is it gauging: expected, realized, or remembered? Research finds these three to be quite different, even when the same person experiences each. Happiness and, in turn, utility are hopelessly malleable concepts.

Since we are strongly predisposed to make cognitive mistakes due to our emotions, then it takes only a small step to conclude that markets cannot be informationally efficient. The evidence supporting this conclusion is vast: There are hundreds of statistically verified anomalies in the academic literature and more continue to be found.

Implications for Investment Management

A bleak picture of markets emerges: Emotional investors, with their cognitive biases and instinct toward herding, constantly drive prices away from the underlying fundamental value. Unexpectedly, analyzing markets through a behavioral lens provides a more reliable framework. Why? Because individuals rarely change their behaviors. And investing crowds are even less inclined to alter their collective behavior.

Behavioral Concept 3: Investor emotions are the most important determinant of long-horizon wealth in an investment portfolio.

We must consider investor emotions and resultant behavior at every stage of investment management. The process begins with client needs-based planning, in which a separate portfolio is built for each different need. This initial planning phase is critical to removing investor emotions from the wealth-building process.

For the growth portion of the portfolio, the focus is on a long investment horizon. The task of the adviser is to encourage clients to adopt this long-term view while avoiding emotional reactions to short-term events. Evidence indicates that such myopic loss aversion decisions have a profoundly negative effect on wealth. Emotional coaching is one of the most important services an adviser can offer clients.

If needs-based planning is successful, the growth portfolio can be largely invested in high expected return but short-term volatile securities like equities. Admittedly, it is a challenge to keep clients fully invested while avoiding costly trading decisions when markets turn volatile.

Behavioral Price Distortions

When an event like the surprise Brexit vote triggers our emotions, most of us react in a similar way. This collective response is further amplified by herding. Indeed, herding can occur even without an external event. We collectively react because we see everyone else reacting, even though we do not know the reason for the sudden stampede.

Emotional crowds rampaging in the markets create numerous buying opportunities for those who are not caught up in the moment. We refer to these opportunities as behavioral price distortions.

In contrast, these are dubbed “anomalies” in the academic literature because their existence is inconsistent with the efficient market hypothesis (EMH). When they are included in asset pricing models or in constructing smart beta portfolios, they are called “factors.” We prefer the term behavioral price distortions because they are the consequence of collective emotional behavior.

Behavioral Concept 4: Behavioral price distortions are common in financial markets and can be used to build successful investment strategies.

Distortions are the ingredients active managers use when creating an investment strategy. In the case of smart beta, they are the entire strategy. For other active managers, they represent only a portion of the strategy because an investment manager’s “recipe” or decision-making process makes up the rest. Behavioral price distortions are essential to successful active management.

A New World View

Viewing investors and markets as emotional and bad decision makers rather than rational computational entities forces us to reconsider every aspect of investment management. These behavioral concepts provide the framework for rethinking client financial planning, asset allocation, investment manager selection, and the creation and execution of investment strategies.

Shifting to a behavioral perspective is the first step in becoming a behavioral financial analyst. It might seem like a radical step, but really it is just the formal recognition of the obvious. Wisdom is seeing the world for what it is, not what we would prefer it to be.

After recognition comes a formal transition to improved analytic tools, several of which we will highlight in future articles. Such tools are the precursors to The Active Equity Renaissance.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/michelangeloop

About the Author(s)
C. Thomas Howard

C. Thomas Howard is the co-founder, chief investment officer, and director of research at AthenaInvest. Building upon the Nobel Prize-winning research of Daniel Kahneman, Howard is a pioneer in the application of behavioral finance for investment management. He is a professor emeritus at the Reiman School of Finance, Daniels College of Business, University of Denver, where he taught courses and published articles in the areas of investment management and international finance. He is the author of Behavioral Portfolio Management. Howard holds a BS in mechanical engineering from the University of Idaho, an MS in management science from Oregon State University, and a PhD in finance from the University of Washington.

Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Voss also sub-contracts for the well known firm, Focus Consulting Group. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: [email protected]

24 thoughts on “The Active Equity Renaissance: Behavioral Financial Markets”

  1. Suresh Patel says:

    The theory of behavioral finance is quite interesting and this article explained it in a very simple way and yes it can be a great alternative.

    1. Hello Suresh,

      Thank you for your comment. In our opinion, there is still much work to be done in this area of research, but we believe what already exists provides a stronger framework for understanding market action than modern portfolio theory.

      Yours, in service,


  2. Fung C.F. says:

    Hi, very well written article, except that there is one concept that I disagree with:

    “Behavioral Concept 3: Investor emotions are the most important determinant of long-horizon wealth in an investment portfolio.”

    should be written as…

    “Behavioral Concept 3: Investor emotions are the most important determinant of SHORT-horizon wealth in an investment portfolio.”

    Emotions fluctuate over the short term but not long term. Over the long run, security prices track fundamentals. As Ben Graham once famously said “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

    1. Hello Fung C.F.,

      Thank you for your praise, and for your comment. I neither agree or disagree with your comment. However, that comment and others like it is tough for me to understand. Why? Because for the those buying and selling securities today, for example, some were purchasing/selling securities with an intended time horizon of just a few seconds, or minutes, or days, or week, or months. But others may have been purchasing/selling securities with an intended time horizon of 3 years, or 5 years, or forever. How do we distinguish who is who from market data? It could be that a short-term time horizon buyer today bought securities from someone that held the same securities for 35 years. I am interested in your thoughts on this issue.

      Yours, in service,


      1. Fung C.F. says:

        Jason, for the sake of this discussion let’s use the most old-school valuation method — dividend yield.

        Dividends have been the most straight forward catalyst in equity investment. Pension funds, endowments and income-oriented mutual funds all seek for yields. Hence, in long run, stock prices track dividends, not emotions. Emotions can deviate the yield by hundreds of bps in short term, but in long run those deviations don’t matter much. A 10% CAGR in dividends over 10-20 years would probably produce a 9-11% CAGR in equity value.

        Many researches showed that equity prices track earnings growth over the long term, i.e. if earnings grow by 10% over 10-20 years, stock price most probably will follow suit (maybe +/-1%).

        BRK is the best example of stock price tracking long-term fundamentals — its book value compounded at 19% annual rate while its market value compounded at 20%. If anything, emotions actually produced only 1% price premium to the growth, and that’s pretty much a Warren-Buffett premium.

        1. Hello again, Fung,

          Thank you for the explanation and clarifying your point of view. It sounds as if you are looking at individual securities and their prices eventually reflecting underlying business performance. However, that is different than the fluctuations of the overall equity market, for which MPT seeks to describe the underlying behavior, and that any rival theory should seek to explain, too. Embedded in the assumption that a security’s price reflects the underlying performance of the issuer is that you have ascribed a fair value to the security and that you have purchased it at a discount to your estimate of fair value. This is a quite different proposition than looking at the overall movements of a market.

          With smiles,


          1. Fung C.F. says:

            I’d like to think my analogies apply to overall market pricing, hence market movement, too. If anything, the correlation should be even stronger than security-specific examples. The S&P 500 compounded at 10% annual rate in the past because earnings have also compounded at similar rate, right?

          2. Hi Fung,

            I think you and I are likely in agreement, but that we have a nomenclature problem. Specifically, the words you are using “short-term” and “long-term” are subjective terms, not objective terms. If I understand your point, it is that you are saying the volatility of returns shrinks over time for those that buy and hold, yes? If so, I have no disagreement with that and it is certainly true. But if I purchase a security today when say the value of COST falls by 40% due to emotions/volatility and then I hold on for ten years. Not only is it likely that I get COST’s earning growth, your point, but I also get excess return, or alpha because of purchasing due to short-term emotions. What Tom is saying, is that long-term returns are improved by taking advantage of emotions, which occur on a day to day basis. To me, this is a likely explanation why there is a value effect in the market.

            If this isn’t what you intended, then please feel free to correct me.

            Yours, in service,


    2. Tom Howard says:

      Fung C. F.

      A couple of responses.

      If you read the text following Concept 3 you will see that we are referring to the necessity of dealing with investor emotions at every stage of the planning/investing process. That is, at each stage if the investor makes emotional decisions, long horizon is reduced.

      And no amount of fancy portfolio construction or investment management can make up for these devastating mistakes. That is why emotions are the most important aspect, by far, for building wealth.

      Second comment, markets are no more correctly priced in the long run as they are in the short run. Emotional crowds dominate in both situations.

      It is true that underlying economic (company) growth acts as a guide-wire for the market (stock), but swings away from this economic pull are large.

      The best we can say is that the market wanders higher over time because the economy grows over time. Believing the market correctly prices securities in the long run is pure fantasy.

  3. Brad Case says:

    Let me raise a purely logical problem with your argument.
    (1) You say that “Rampaging emotional crowds cause extreme volatility of returns.” (I disagree, but let’s leave that aside.) Now, keep in mind that every single member of your “rampaging emotional crowd” is–by definition–an active investor.
    (2) You view “(active) investors and markets (driven by active investors) as emotional and bad decision makers.”
    (3) And yet you say that “Distortions are the ingredients active managers use when creating an investment strategy.”
    Given that you think active investment is driven by rampaging emotions (rather than rational analysis) and results in bad investment decisions, wouldn’t we want to completely eliminate active management?

    1. Chuck t says:

      I agree Brad. We are trying to predict the future returns in an inefficient mkt of irrational investors with a history of herding. Too complex of a problem for me. Thats why i just concern myself with diversification, simple asset allocation weighting, and inexpensive ETFs. I spent way too much time and money trying to do the impossible. Reading Greek philosophy would have been a better use of my time.

      1. Hi Chuck,

        Might I point out that you still have an ex ante problem with diversification, simple asset allocation weighting, and inexpensive ETFs? For you to do that well you still need to have a point of view. In this case, a critical assumption on your part is those choices will work well in the future, too. Yes?

        Yours, in service,


        1. Chuck t says:

          I appreciate your articles and have learned a lot from them. We all have an ex ante problem and different approaches to try and mitigate it, some better than others. The questions to ask , how much time and money do i spend on it and how much extra return am i getting for my cost? Everyone is going to have different answers to those questions. Personally, a simplified, diversified, low cost portfolio works best for me. I suspect that it would work best for most people but not all. Thanks again.

          1. Hi Chuck,

            Kind words; thank you. Through the years as I have counseled analyst interns, research analysts, and several portfolio managers, I think the most important thing for investment decision makers to do is to find tools that exalt their consciousness, and compensate for any shortcomings. We all have these exalted aspects and weaknesses. That you have found tools that work for you is no small thing in my opinion.

            Yours, in service,


    2. Hi Brad,

      I know that you are a very logical thinker, and that is aptly demonstrated by your comment library. Tom and I believe it is time for active managers to change how they invest. That is been the idea behind each article in this series. Not defending active management for how it has been executed, but instead pointing out the changes that need to be made in order for it to be done better, and perhaps even well. In your nested argument the answer to the question is that we are saying to transition from 2 to 3 there needs to be a recognition of what is wrong (see posts 1-4 for a sampling of these thoughts), and a change needs to be made to do more of what is right (see posts 5-8 for a sampling of these thoughts). In fact, I think your nested and hierarchical logic is a perfect description for how we thought about creating this series of articles.

      Yours, in service,


    3. Fung C.F. says:

      “Given that you think active investment is driven by rampaging emotions (rather than rational analysis) and results in bad investment decisions, wouldn’t we want to completely eliminate active management?”

      Active management is a negative-sum game — a third outperforms while two thirds underperform, partially thanks to transaction costs. The outperforming guys (who perform rational analysis) definitely do NOT wish the active game to go away because they’ve been profiting from the underperforming guys (the so-called rampaging emotional crowds).

      So no (ironically), nobody wants to eliminate active management because the rational winners are enjoying it while the emotional losers still think they can win.

      1. Fung C.F. says:

        My comment “…partially thanks to transaction costs” should be corrected to “…partially thanks to the high active-management fees”

      2. Hello again, Fung,

        Tom and I have addressed this common fiction that investing in active management is a zero-sum game. I cannot remember which of the posts in this series in which we addressed the point; sorry thus, if you go to find it. But the short story is that the underlying assumption of MPT and of CAPM is that there is an underlying market portfolio for ALL assets, including things like your mother’s silverware heirlooms. The market that includes all assets IS zero sum. Put another way, there is a hidden assumption in the zero-sum claim, that everyone has access to, and is selecting securities from the same ‘market’ portfolio. But given the impossibility of that assumption, in practice, it is entirely possible for an active manager to hold securities that competitor’s do not. One simple example, is that when I was a portfolio manager the fund I managed ended up being the only holder of a convertible security as all others had cashed it in and the issuer actively bought them back in the market.

        Yours, in service,


      3. Tom Howard says:

        Fung C. F.-

        I agree with your comment and it represents a good response to Brad’s “logical argument”.

  4. I.K. Opoku-Ahwenie says:

    Great insight into the world of market and investment. Your article kinda serve as an eye opener to those of us who are still at the teething stages in our finance and investment studies.
    Inasmuch as I agree with your article I also felt we can’t just abandon the MPT when it comes to markets and investment. Human emotions and behaviours though drive the market to a large extent it will be very hard to teach investment and finance without a model representation of the real world situation without certain theories and assumptions like the MPT and the Utility concepts in economics.
    So the fundamentals are still relevant in academia and finance models.

    1. Tom Howard says:


      I taught investment management at the graduate level for the last 20 years of my 33 year academic career without using any MPT concepts. I have run my my investment management company for 12 years using purely behavioral concepts.

      I am here to tell you that their is life after MPT!

      I know where you are coming from. I sweat blood in the PhD program to master every aspect of MPT, down to building mathematical models and testing predictions. It took me considerable time to move away from these ideas (sunk cost error) and onto behavioral finance.

      I am certainly glad I did, but each of us is on their own unique path within this ongoing industry transition.

  5. Aniket A. Mirajkar says:

    Hello All,

    In my opinion we use number of qualitative and quant methods to come up with required value of a share, but what lie beneath the output of these methods are assumptions that we make. From revenue to dividend we put forward our expectations to come up with final valuation of any company or stock. But the question remains from where these assumptions come?
    1. Years of experience in industry
    2. Future expectations and macro indicators
    3. Personal opinions about certain company or market etc.
    If above mentioned traits are with us, then why we (investors and traders) react to market fluctuations?
    Number of examples can be given for this which proves we react to market movement with emotions and which in turn again moves the market. E.g. For 2008 recession and reaction to it where all stocks got beating even when some them were fundamentally very strong in long-term (guess what analysts only gave them these high valuations).
    The only reason is behavioral aspect which led to such erratic movement in market where even best companies lost chunk of their value.
    Similarly we can observe this phenomenon with individual stock as well. When stock reaches new high people tend to sale it and once selling starts stock losses its value and recovers once selling pressure goes away. Which proves not all, but many of us follow behavioral pattern while investing or trading.
    Software and technology companies can be a very good example for study of how people react to market based on emotions only. These companies practically gain 1000% within few years and lose their value in same manner e.g. Yahoo Inc.

    1. Hello Aniket,

      I really like what you wrote; well said, in my opinion. I think you may appreciate research that I conducted several years ago that shows that, on average, on a day, that well less than 1% of investors trade globally. In other words, prices are set at the margin. So it does not take too many nervous investors to move market prices up or down:

      Thank you for your participation in the discussion!


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