Behavioral Portfolio Theory

TLDR

The study develops a positive behavioral portfolio theory and examines its implications for portfolio construction and security design. The authors introduce two versions of BPT—single and multiple mental account models—where investors either aggregate assets into one account or segregate them into layers aligned with different aspiration levels, such as a low‑risk poverty‑avoidance layer and a high‑risk wealth‑seeking layer. Optimal BPT portfolios combine bonds and lottery tickets, differ from mean‑variance and CAPM efficient portfolios, and in the multiple‑account version appear as layered pyramids linked to distinct aspiration levels.

Abstract

We develop a positive behavioral portfolio theory (BPT) and explore its implications for portfolio construction and security design. The optimal portfolios of BPT investors resemble combinations of bonds and lottery tickets, consistent with Friedman and Savage's (1948) observation. We compare the BPT efficient frontier with the mean-variance efficient frontier and show that, in general, the two frontiers do not coincide. Optimal BPT portfolios are also different from optimal CAPM portfolios. In particular, the CAPM twofund separation does not hold in BPT. We present BPT in a single mental account version (BPT-SA) and a multiple mental account version (BPT-MA). BPT-SA investors integrate their portfolios into a single mental account, while BPT-MA investors segregate their port? folios into several mental accounts. BPT-MA portfolios resemble layered pyramids, where layers are associated with aspirations. We explore a two-layer portfolio where the low aspiration layer is designed to avoid poverty while the high aspiration layer is designed for a shot at riches.