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2.1.1 Portfolio Construction

The simplicity of the Mean–Variance (MV) model posited in MPT suggests that it should be a relatively easy task for the average investor to create a reasonably efficient portfolio over a long-term horizon. However, behavioural finance suggests otherwise with the investor performing poorly over a long period. As per MPT, investors are supposed to maximise portfolio expected return for a given amount of risk, or equivalently minimise risk for a given level of expected return (Markowitz 1952), but this rarely occurs in reality. Instead, investors seem to do everything else but that (sentence incomplete). For example, they are more comfortable with focusing their portfolios on the assets, for example, domestic assets and their employer's stocks, regardless of whether this may increase the overall risk of the investment portfolio (Huberman 2001). The above phenomenon is known as home bias,[1] resulting in a focus on domestic securities despite, the possible reduction in risk by international diversi- fication (Tesar and Werner 1995). Investors in more patriotic nations hold smaller amounts of international equities (Morse and Shive 2011), very different from the predictions of asset pricing models, which state that investors should hold the world market portfolio of all countries in proportion to each country's market capitali- sation. Home bias is extensive across countries (Chkioua and Abaoub 2012), although varying greatly in effect (Solnik and Zuo 2012), and has fallen in recent years (Foad 2012). Several reasons have been put forward, such as a desire to hedge domestic inflation, but such an explanation does not yield as equities do not hedge inflation in such a way, given the investment horizon of most portfolios. Other explanations, such as investors being more optimistic about local equities than compared to foreign investors (French and Poterba 1991) or the existence of international boundaries resulting in exchange risk, etc. (Ke et al. 2009) have been put forward, but these are hard to model, and thus far not proven conclusively, similar to other investor idiosyncrasies.

Overconfidence is also a key factor in constructing portfolios, wherein investors, whilst aware of the benefits of diversification, hold under-diversified portfolios due to an illusory sense of control which makes them adopt naive diversification strategies (Goetzmann and Kumar 2001). Overconfidence explains much in the area of portfolio selection, such as why portfolio managers trade so much and why pension funds hire active equity managers, all strategies that are inconsistent with notions of rationality (Thaler and Bondt 1995).

  • [1] Home bias refers to the tendency of investors to invest in a large and disproportionate amount of domestic equities, relative to their overall portfolio
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