Redefining Risk from a Value Investing Perspective: Propositions to Motivate a Re-Examination of Standard Portfolio Theory and Asset Pricing Models

Abstract

Modern Portfolio Theory and Asset Pricing Models have major limitations as systems for modeling investor portfolio choices and prices of financial assets. Financial market participants are not a uniform group of rational investors. Instead, they are an amalgamation of heterogeneous traders with varied and sometimes very divergent goals. In fact, not every financial market participant is an investor. Even the investors in the market operate in a manner such that a lot of decisions do not line up with rationality. Thus the current paradigm of using Modern Portfolio Theory to represent the activities of market participants as rational investors leads to predictions that do not fit what is observed in financial markets. First, we define investment and an investor from a Value Investing perspective according to Benjamin Graham. We present a number of propositions based on critiques of Modern Portfolio Theory that are becoming common in the literature to focus discussion on ways to view investment operations from a value investing perspective as propounded by Benjamin Graham. These propositions deal mainly with how investors perceive and handle risk in their portfolio management decisions. We conclude that we have the tools and methodology to develop portfolio theory that incorporates time and investor behavior that is different from the homogeneous group of ultra-rational decision makers on whom the current models are based.