Impact of behavioral biases on portfolio performance

Details

Supervisors

Vrins, Frédéric

Faculty

Louvain School of Management

Degree label

Master [120] : ingénieur de gestion, à finalité spécialisée

Abstract

The modern portfolio theory developed by Harry Markowitz serves as a reference when discussing finance. However, over the past decades, behavioral finance has emerged because classical theory failed to explain all the phenomena occurring in financial markets. By studying investors' behavior and their decision-making under uncertainty, behavioral finance aims to describe and reflect the world as it actually unfolds, disregarding simplifying assumptions. The purpose of this paper is to compare the investments made by market participants with their natural behavioral biases to those considered theoretically optimal according to modern portfolio theory. To achieve this, optimal portfolios based on the theory were selected from a historical dataset of asset returns from the EuroStoxx 50. These portfolios were then compared to their alternatives, considered optimal in the eyes of investors. This difference arises because human behavior perceives things differently than they actually are, leading to unconscious modifications of data. The results revealed that, in general, the future performance of behavioral portfolios was superior to their theoretically optimal counterparts. This can be partly explained by the fact that markets react on a large scale according to these behavioral patterns. Consequently, investors' choices are unconsciously better than the theory's predictions, as it is the aggregation of all these choices that defines the market outcomes.