Behavioral Portfolio Theory

Abstract

The aim of this study is to explain behavioral portfolio theory in a theoretical way. The study starts with the definition of portfolio which is a financial asset that consists of various securities such as stocks and bonds and derivative products, held by a particular person or group. Also, portfolio management is the management of securities according to investors’ returns and risk targets. There are two basic portfolio management theories in finance literature. The first is the traditional portfolio (simple diversification) approach based on the diversification of securities. The second is the modern portfolio theory, which is based on a more mathematical basis. Modern portfolio theory mathematically shows the measurement of the risk and return of a portfolio of two or more securities and the determination of optimal portfolios. Markowitz’s mean-variance model is the first mathematical explanation of the idea of diversifying investments and is the cornerstone of many risk models developed such as capital asset pricing model and arbitrage pricing model in later years. The empirical studies reveal that investors do not act rationally as financial models assume and anomalies occur. Thus, behavioral finance tries to fill the gap in this area and states that investors should be considered “normal” rather than rational. Prospect theory developed by Kahneman and Tversky (1979), brings psychological explanations to finance issues. Mental accounting in behavioral finance prevents the rule of taking into account the correlation between the returns of an investment. Also, herd behavior of investors distorts the efficiency of the markets and leads to volatility in financial markets. When investors show herd behavior, they do not care about the information received and tend to imitate other investor behavior. Behavioral portfolio theory (BPT) emerged as a descriptive alternative to Markowitz’s mean-variance portfolio theory. BPT connects two issues, the creation of portfolios and the design of securities. There are two versions of the BPT model: single mental accounting (BPT-SA) in which the portfolio is integrated into one mental accounting and multiple mental accounting (BPT-MA).