Postmodern Portfolio Theory: Navigating Abnormal Markets and Investor Behavior

345 Pages·2016·5.1 MB·English

by  James Ming Chen (auth.)

POSTMODERN
PORTFOLIO
THEORY
Navigating Abnormal
Markets and
Investor Behavior
JAMES MING CHEN
Quantitative Perspectives on Behavioral
Economics and Finance
Series Editor
James  Ming Chen
College of Law
Michigan State University
East Lansing ,  Michigan , USA
The economic enterprise has fi rmly established itself as one of evaluating
human responses to scarcity not as a rigidly rational game of optimiza-
tion, but as a holistic behavioral phenomenon. The full spectrum of social
sciences that inform economics, ranging from game theory to evolution-
ary psychology, has revealed the extent to which economic decisions and
their consequences hinge on psychological, social, cognitive, and emo-
tional factors beyond the reach of classical and neoclassical approaches
to economics. Bounded rational decisions generate prices, returns, and
resource allocation decisions that no purely rational approach to optimiza-
tion would predict, let alone prescribe.
Behavioral considerations hold the key to longstanding problems in
economics and fi nance. Market imperfections such as bubbles and crashes,
herd behavior, and the equity premium puzzle represent merely a few
of the phenomena whose principal causes arise from the comprehensi-
ble mysteries of human perception and behavior. Within the heterodox,
broad-ranging fi elds of behavioral economics, a distinct branch of behav-
ioral fi nance has arisen.
Finance has established itself as a distinct branch of economics by apply-
ing the full arsenal of mathematical learning on questions of risk manage-
ment. Mathematical fi nance has become so specialized that its practitioners
often divide themselves into distinct subfi elds. Whereas the P branch of
mathematical fi nance seeks to model the future by managing portfolios
through multivariate statistics, the Q world attempts to extrapolate the
present and guide risk-neutral management through the use of partial dif-
ferential equations to compute the proper price of derivatives.
The emerging fi eld of behavioral fi nance, worthy of designation by the
Greek letter psi (ψ), has identifi ed deep psychological limitations on the
claims of the more traditional P and Q branches of mathematical fi nance.
From Markowitz’s original exercises in mean-variance optimization to the
Black-Scholes pricing model, the foundations of mathematical fi nance
rest on a seductively beautiful Gaussian edifi ce of symmetrical models and
crisp quantitative modeling. When these models fail, the results are often
catastrophic.
The ψ branch of behavioral fi nance, along with other “postmodern”
critiques of traditional fi nancial wisdom, can guide theorists and practi-
tioners alike toward a more complete understanding of the behavior of
capital markets. It will no longer suffi ce to extrapolate prices and forecast
market trends without validating these techniques according to the full
range of economic theories and empirical data. Superior modeling and
data-gathering have made it not only possible, but also imperative to har-
monize mathematical fi nance with other branches of economics. Likewise,
if behavioral fi nance wishes to fulfi ll its promise of transcending mere cri-
tique and providing a more comprehensive account of fi nancial markets,
behavioralists must engage the full mathematical apparatus known in all
other branches of fi nance. In a world that simultaneously lauds Eugene
Fama’s effi ciency hypotheses and heeds Robert Shiller’s warnings against
irrational exuberance, progress lies in Lars Peter Hansen’s commitment to
quantitative rigor. Theory and empiricism, one and indivisible, now and
forever.
More information about this series at
http://www.springer.com/series/14524

James  Ming C hen
Postmodern Portfolio
Theory
Navigating Abnormal Markets and Investor
Behavior
James  Ming Chen
College of Law
Michigan State University
East Lansing, Michigan, USA
Quantitative Perspectives on Behavioral Economics and Finance
ISBN 978-1-137-54463-6 ISBN 978-1-137-54464-3 (eBook)
DOI 10.1057/978-1-137-54464-3
Library of Congress Control Number: 2016942679
© The Editor(s) (if applicable) and The Author(s) 2 016
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To Heather Elaine Worland Chen, with all my love

A
CKNOWLEDGMENTS
This book incorporates ideas from papers I have presented at the University
of Cincinnati, Florida State University, Georgetown University, Michigan
State University, the University of Pennsylvania, the University of Virginia,
and the Faculty of Economics of the University of Zagreb (Ekonomski
Fakultet Sveučilišta u Zagrebu). The International Atlantic Economic
Society and the ACRN Oxford Academic Research Network have pro-
vided multiple platforms for the work underlying this book. Along the
way, I have benefi ted from scholarly and professional interactions with
Anna Agrapetidou, Abdel Razzaq Al Rababa’a, Moisa Altar, Christopher
J. Brummer, Irene Maria Buso, Adam Candeub, Seth J. Chandler, Felix
B. Chang, Tendai Charasika, César Crousillat, David Dixon, Robert
Dubois, John F.  Duffy, Daniel A.  Farber, Christopher C.  French,
Santanu K.  Ganguli, Tomislav Gelo, Periklis Gogas, Gil Grantmore,
Andy Greenberg, Losbichler Heimo, Hemantha Herath, Jesper Lyng
Jensen, Jagoda Kaszowska, Daniel Martin Katz, Yuri Katz, Imre Kondor,
Carolina Laureti, Cordell Lawrence Jr., Cordell Lawrence Sr., Matthew
Lee, Othmar Lehner, Heimo Losbichler, Gerry Mahar, Milivoj Marković,
L. Thorne McCarty, Steven C. Michael, Ludmila Mitkova, José María
Montero Lorenzo, Kevin Lynch, Laura Muro, Vivian Okere, Merav
Ozair, Elizabeth Porter, Mobeen Ur Rehman, Carol Royal, Bob Schmidt,
Jeffrey A. Sexton, Galen Sher, Ted Sichelman, Jurica Šimurina, Nika Sokol
Šimurina, Robert Sonora, Lisa Grow Sun, Elvira Takli, Peter Urbani,
Robert R. M. Verchick, Benjamin Walther, Karen Wendt, Gal Zahavi, and
Johanna F. Ziegel. Christian Diego Alcocer Argüello, of Michigan State
University’s Department of Economics, provided very capable research
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