VOICES FROM THE INDUSTRY: Are you a rational investor in today's irrational market?

May 19, 2008

A volatile market is turning the rational investor irrational.

Irrationals show up when markets get volatile or decline. They surface to buy stocks during bubbles, such as the dot-com boom in the late 1990s and early 2000. They react to the news of the day.

Let's start with a bit of education about what a rational investor looks like. Then outline how to adjust behaviors to remain rational-and actually benefit-during market ups and downs.

What is a rational investor?

Dr. Harry Markowitz, Nobel Prize winner and founder of Modern Portfolio Theory, first coined the term "rational investor." In his landmark paper, "Portfolio Selection," published in 1952 by the Journal of Finance, he said a rational investor would choose a portfolio characterized by the highest expected return with the least level of risk. One requirement in creating such a portfolio is diversification among securities that are not highly correlated, an "efficient portfolio."

Being a rational investor and creating an efficient portfolio is difficult. Markowitz began his groundbreaking paper with this statement:

"The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of the portfolio."

In essence he says that a rational investor must make assumptions about future investment correlations and performance!

What if assumptions are wrong?

The price of a stock is not affected by whether the purchase or sale decision was rational or irrational. Therefore, many of the risk-management assumptions made by a rational investor, per Modern Portfolio Theory, become untrue when markets become emotional and volatile. After all, we are all subject to changes in emotion.

With increased market volatility, like what we're witnessing today, it becomes difficult to remain rational. The most important law in investing is the law of supply and demand. The only way a security can appreciate is when there is more demand than supply (more investors initiating buys than sells).

The law of supply and demand is driven by social rather than natural science. In other words, supply and demand-and the resulting changes in price-are driven by buy and sell decisions based on individual beliefs and emotions. Key in today's market-don't get emotional.

What about Wall Street?

Wall Street has a well-documented record for poor risk management, particularly as it relates to the risk associated with unexpected events. The current primelending mess is one many examples of Wall Street's inability to manage "event risk." Why?

Most of Wall Street's strategies for risk management are based on the traditional bell curve distribution standard deviation of risk. This theory generally works during normal market environments.

The problem today: standard deviation does not accurately reflect the probability of devastating event-driven risks. As a result, Wall Street's traditional approach tends to fail when we need it most-such as in the case of a 9-11 or the burst of the dot-com bubble.

How important is event risk?

Monitoring for increases in market volatility can be a useful tool in managing event risk. Volatility can also create opportunities for portfolio appreciation. Most of the money made-or lost-in the market occurs over short time periods and when volatility is highest. Increasing volatility generally precedes a market decline.

What should I do to be rational?

For protection in a volatile market, risk management is the most important tool.

Adjustments need to be made in your portfolio (such as asset allocation, investment asset selection) to maintain consistent portfolio volatility.

Diversify among unrelated asset classes and non-correlated securities. Remember when volatility is high most stocks correlate higher.

Avoid overconfidence or fear.

If you manage for portfolio risk, you can weather and benefit from today's irrational market.

Hardin is managing director and chief investment officer for locally based Canterbury Investment Management LLC. Views expressed here are the writer's.
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