Sanjiv Das, Professor of Finance and Data Science at Santa Clara University’s Leavy School of Business, spoke with everyoneINVESTED’s Jurgen Vandenbroucke about his view on building portfolios to live through corona times.
QUESTION: The classical view on portfolio theory combines asset classes such as equity and fixed income in a proportion that aligns with the investor’s balance between risk and reward. What are, according to you, the main insights that behavioral finance adds to this classical view on portfolio theory?
Behavioral finance accommodates investors’ preferences that may depend not only on reward versus risk but also on psychological considerations (my colleague Hersh Shefrin’s book title says it all: “Beyond Greed and Fear”).
Behavioral finance intersects portfolio construction with cognitive behavior models. The fact that these cognitive issues matter to investors means that insights from behavioral finance theories must be incorporated into constructing portfolios that better reflect investor preferences.
A critical insight is that these cognitive effects are hardwired into investor behavior. Thus, rather than change investors, behavioral finance suggests that we adapt portfolio theory to accommodate investors’ cognition better to deliver them successful portfolios that also enable them to “sleep well at night.”
QUESTION: The classical view on portfolio theory was pioneered by Harry Markowitz, who received the Nobel Prize in Economics in 1990. His views had a significant impact on the asset management industry. You recently collaborated with professor Markowitz on research that integrates a behavioral view to this classical approach. Do you think behavioral finance will have an equally profound impact on how investors build portfolios or take investment decisions?
Yes, of course! I believe it will have a massive impact for three reasons.
First, in recent work with my colleague in the math department, Dan Ostrov, and two practitioners, Deep Srivastav and Anand Radhakrishnan, we have developed a dynamic implementation of GBWM that extends my work in a static model with Harry Markowitz, Meir Statman (well-known for his work on the disposition effect, behavioral portfolio theory), and Jonathan Scheid (a practitioner).
Second, the behavioral approach accounts for upside and downside risk, which may also be mapped seamlessly into this paradigm, as shown in recent work with Jurgen Vandenbroucke.
Third, the essential feature of the behavioral approach is that it is related to an investor’s long-term goals, which complements traditional portfolio theory that is more focused on the short-term performance of a risk-reward optimized portfolio versus its benchmark. We show that it is feasible to maximize the probability of reaching long-term goals using mean-variance optimal portfolios, thereby offering a dynamic overlay to implement behavioral finance models on top of traditional portfolio construction.
For these reasons, I believe that behavioral finance is poised to make a critical impact on wealth management practice.
QUESTION: Financial institutions aim to improve the digitization of the investment process. Your research also relates to so-called artificial intelligence and machine learning. Do you see applications of this research in the context of personal finance?
Personal finance is indeed a fertile ground for FinTech in general and, in particular, AI/ML-intermediated disruption. This disintermediation will bring down the cost of personal finance products for the small investor. Robo-advising is an obvious example, and soon, this will be AI-empowered, using Chatbots to replace human advisors, and offer far more customization than we have today. Customer retention in the personal finance space will be enhanced using the data in ML models. The use of social media data in personal credit extensions is already widespread. These few examples demonstrate the success of AI/ML, based on big data and algorithms.
Sanjiv Ranjan Das is the William and Janice Terry Professor of Finance and Data Science at Santa Clara University’s Leavey School of Business. Professor Das has published extensively on a wide range of topics, including collaborations with Harry Markowitz (founding father of classic portfolio theory) and Meir Statman (one of the founding fathers of behavioral portfolio theory). Professor Das also collaborated with Jurgen Vandenbroucke, managing director everyoneINVESTED
Picture: Jurgen Vandenbroucke and Sanjiv Das, Santa Clara University