Morningstar Magazine - April/May 2018 - 8

Dispatches

Build Bridges, Not Walls
How popularity
connects classical and
behavioral finance.

Phillips Curve
12

The Utility of Grades

13

Is Greed Good?

15

Anatomy of a Debacle

18

Policy
U.S. Wants to Help Investors. Does It?

LETTER FROM THE BOARD

Paul D. Kaplan

Ivory Towers

The Old Squirrel

Behavioral Insights
20

Looking Beyond the Markets
Global Briefs

22
27
29

Financial economics, like other fields, can be rife
with controversy. Perhaps one of the greatest
controversies has been that between classical and
behavioral finance. Clearly, economists on both
sides have made significant contributions to our
understanding of how investors behave and how
financial markets work, as is evident in that
leading thinkers from both schools have received
the Nobel Memorial Prize in Economic Sciences.

Americas
Greater Europe
Asia

So, if both schools have something to contribute,
is it possible to reconcile their theories and
find a middle ground? I believe that the answer is
yes. In fact, I am working with an academic (Yale's
Roger Ibbotson) and two of my colleagues at
Morningstar (Thomas Idzorek and James Xiong) on
a monograph to be published by the CFA Institute
Research Foundation called "Popularity: A
Bridge Between Classical and Behavioral Finance."
As the title says, we think that our approach,
which we call popularity, provides a bridge
between the opposing camps.1 Below, I outline
what we cover in the monograph. But before I
do, I first explain my own journey from neoclassical
economics to developing the theoretical basis
for popularity, which incorporates elements of both
classical and behavioral finance.
Learning Economics

My first exposure to economics came in high
school. In New York City, economics was
a required class, and I was fortunate to have an
inspiring teacher. We covered topics including the

1 Ibbotson and Idzorek (2014) introduced the concept of popularity.

8

Morningstar April/May 2018

stock market, and some basic microeconomics,
such as supply-and-demand curves. In college,
when I took a more advanced course in
microeconomics, I learned how to graphically
derive demand curves from the assumption that
consumers maximize their utility and supply curves
from the assumption that firms maximize profits.
In graduate school, I learned the neoclassical
mathematical models of consumer and producer
behavior and general equilibrium. In these models,
economic agents are completely rational and
operate in purely competitive markets. Taking
prices as given, neoclassical economics assumes
that economic agents not only know their objective
functions and constraints but can solve their
optimization problems as if each person were a
computer. This is the assumption of rationality that
behavioral economists find so objectionable.
Learning Classical Finance

Eventually, my interests shifted from general
economics to finance. My economics training laid
the foundation for understanding the capital asset
pricing model, the intertemporal capital asset
pricing model, and arbitrage pricing theory. I wrote
my dissertation on asset-pricing theory and
estimating asset-pricing models.
In these classical asset-pricing models, agents
are rational and have rational expectations.
Furthermore, active portfolio management is futile
if the efficient-market hypothesis-proposed
by Eugene Fama (1970), who would go on to win
a Nobel prize-holds. According to the EMH,
all information relevant to security prices is already
reflected in those prices, so there is no point in
trading based on any given piece of information.
As elegant, or perhaps simplistic, as the CAPM and
the EMH are, empirical regularities cast doubt
on them. According to the CAPM, the expected
return of each security should depend on its
systematic risk with respect to the market as
a whole-its beta. But a large body of research
shows that several other factors, such as
market capitalization, valuation ratios, and return
volatility, are related to expected return.



Table of Contents for the Digital Edition of Morningstar Magazine - April/May 2018

Contents
Morningstar Magazine - April/May 2018 - Cover1
Morningstar Magazine - April/May 2018 - Cover2
Morningstar Magazine - April/May 2018 - 1
Morningstar Magazine - April/May 2018 - 2
Morningstar Magazine - April/May 2018 - Contents
Morningstar Magazine - April/May 2018 - 4
Morningstar Magazine - April/May 2018 - 5
Morningstar Magazine - April/May 2018 - 6
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