The neo-classical finance theory which is onset of Markowitz's portfolio selection theory(1952) is mostly based on the following assumptions: The investors' behavior are completely rational, the actions of all the investors are guided by the criterion of maximizing expected utility; And simultaneously the markets are efficient (EMH). As Fridson (1994) asserted, based upon the normative assumptions and the EMH, rational and fully informed investors (i.e., representative agents) quickly eliminate any tendency of a class of securities to deviate, on a risk-adjusted basis, from a market rate of return and thereby forcing their prices to resume or converge to their equilibrium level which reflect their true fundamental values. Based on these two assumptions, the neo-classical finance theories try to use decision-making model to explain what is the best decision and to discuss the investors' behavior during the decision- making procedure. However, in reality, the assumption of rational investors follow the optimality principle seems not strong enough. In this paper, I critically discuss the validity of this approach and its potential to serve as a normative theory of asset allocation.
The remainder of this paper is organized as follows. Section 2 presents the nature of human being and discusses why investors are not rational. Section 3 presents the reason of human's irrationality. Section 4 summarizes the main results and presents conclusions. .
2. Is the human being rational or not.
In the Markowitz's portfolio selection theory(1952), he assumed that the investor is risk averse, for any desired level of mean return, the investor wants to minimize risk, measured by portfolio variance or standard deviation. But in reality, this assumption might never be true. As we know that, human being is a thoughtful emotional and rational synthesis. When we are making decision, not only the emotion often becomes the main power, but also the rationality cannot help us to solve all the problems.
