A Critique of Modern Portfolio Theory and Asset Pricing Models Based on Behavioral Insights from Benjamin Graham's Value Investing Paradigm

Abstract

Modern Portfolio Theory, the Capital Asset Pricing Model, and the Efficient Market Hypothesis are the cornerstone concepts in both academic and professional curricula. In spite of their long history and reputation, the CAPM and its extensions are not able to yield satisfactory empirical results. We argue that this is because the modelling process ignored the impact of human behavior in financial markets. We present a critique of these standard models using behavioral insights from Benjamin Graham’s value investing paradigm. We propose that if, instead of getting fixated on investors’ optimal rational decision making, we adopt Benjamin Graham’s value investing perspective which explicitly acknowledges that investor decision making is by definition imperfect primarily due to psychological biases, we would be able to derive better investment decision making processes.

Keywords: behavioral finance, value investing, asset pricing, volatility, history of thought

JEL Classification: G02, G11, G12