Redefining Risk and Return in Common Stock Investment

Modern Portfolio Theory, standard asset pricing models and the concept of rational decision makers in efficient markets have major limitations as systems for modeling investor behavior 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; a significant number of financial market participants are speculators. Thus, the current paradigm of using Modern Portfolio Theory to represent the activities of market participants as "investor behavior" leads to predictions that do not fit the outcomes that are observed in financial markets. First, we define "investment" and "an investor" from a value investing perspective according to Benjamin Graham. After discussing some of the standard conclusions of Modern Portfolio Theory and traditional asset pricing models, we present a number of propositions to motivate discussion on ways to rethink the current prevailing view of what is investment and who is an investor. This is with a goal to nudge academic finance back to the ideas of Benjamin Graham as encapsulated in the value investing paradigm, a system of investment decision making that has withstood the test of time and economic, business and financial cycles for over 80 years. We focus particularly on how investors perceive and handle risk in their portfolio management decisions. We conclude that the core value investing framework, as well as analytical tools and methodology as handed down by Benjamin Graham, are capable and sufficient 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 popular models are based.