Question

Which of the following choices are accurate descriptions of the differences between Modern Portfolio Theory (MPT) and Behavioral Finance (BF)? Check all that apply.

	a.	Investors are risk-averse in MPT, and they are also risk-averse in BF.
	b.	With MPT investors act in their own self-interests, while with BF investors act in the best interest of the market investors as a whole
	c.	With MPT investors seek to maximize utility while with BF investors seek to minimize regret.
	d.	With MPT securities are valued rationally and with BF securities are valued heuristically.
	e.	With MPT new information is priced accordingly, and with BF new information is not immediately priced into the security.
	f.	With MPT investors possess perfect information and with BF investors possess imperfect information.

Answer 1

Before we get into the answer, Let us understand both these theories in a bit detail

Modern Portfolio Theory (MPT)

The inheret assumption is that, markets are believed to be efficient and those who invest always make smart, forward thinking decisions. These people have access to market information so the securities are always accurately priced.

Another aspect of the MPT is that by spreading your investments across different types of securities, you can reduce the volatility of your portfolio and enhance its performance.

MPT believes that an optimal portfolio is the one that balances lowest level of risk for a given amount of return

Behavioral Finance

While we all dream of a perfect world, unfortunately, the markets are anything but predictable. As a result, we turn to behavioral finance. Behavioral finance is all about the roles emotions and psychology play when someone is making important investment decisions. Because we are far from perfect oftentimes, our own human nature can get in the way of us making rational, predictable decisions. We are not always able to act in the most logical way possible

Now let us select the correct answers

c - MPT investors only care about returns, but BF investors want to minimize regret, which can come because of getting too emotional about your investments

d - MPT think securities are priced immediately as everyone has same info, but according to BF, there is info assymtery and it happens heuristically

e - MPT says new info is priced immediately but according to BF, there is info assymtery and it happens heuristically

f - Real markets have an information assymetry and hence against MPT beliefs