LESSON 3 BPT-Behavioural portfolio theorypptx presentation
- 1. Behavioral Portfolio Theory • Behavioral portfolio theory, introduced by Shefrin and Statman (2000), is a goal based theory. In that theory, investors divide their money into many mental account layers of a portfolio pyramid corresponding to goals such as having a secure retirement, paying for a college education, or being rich enough to hop on a cruise ship whenever they please.
- 2. `` • The road to behavioral portfolio theory Started more than 60 years ago when Friedman and Savage (1948) noted that hope for riches and protection from poverty share roles in our behavior; people who buy lottery tickets often buy insurance policies as well.
- 3. • So, people are risk-seeking enough to buy tickets while they are risk-averse enough to buy insurance. Four years later, Markowitz wrote two papers that reflect two very different views of behavior. In one (Markowitz 1952a), he created mean-variance theory, Based on expected utility theory;
- 4. • in the other (Markowitz 1952b), he extended Friedman and Savage’s insurance-lottery framework. People in mean-variance theory, unlike people in the insurance-lottery framework, never buy lottery tickets; they ARE risk averse, never risk seeking
- 5. • Friedman and Savage (1948) observed that people buy lottery tickets because they aspire to reach higher social classes, whereas they buy insurance as protection against falling into lower social classes. Markowitz (1952b) clarified the observation of Friedman and Savage by noting that people aspire to move up from their current social class or “customary wealth
- 6. • A central feature in behavioral portfolio theory is the observation that investors view their portfolios not as a whole, as prescribed by mean-variance portfolio theory, but as distinct mental account layers in a pyramid of assets, where mental account layers are associated with Particular goals and where attitudes toward risk vary across layers. One mental account layer might be a “downside protection” layer, designed to protect investors from being poor
- 7. • Another might be an “upside potential” layer, designed to give investors a chance at being rich. Investors might behave as if they hate risk in the downside protection layer, while they behave as if they love risk in the upside potential layer. These are normal, familiar investors, investors who are animated by aspirations, not attitudes toward risk.
- 8. • Another might be an “upside potential” layer, designed to give investors a chance at being rich. Investors might behave as if they hate risk in the downside protection layer, while they behave as if they love risk in the upside potential layer. These are normal, familiar investors, investors who are animated by aspirations, not attitudes toward risk.
- 9. • Mean-variance portfolio theory and behavioral portfolio theory were combined Recently as mental accounting portfolio theory. Investors begin by allocating their wealth across goals into mental account layers, say 70 percent toretirement income, 20 percent to college funds, and 10 percent to being rich enough to hop on a cruise ship whenever they please.
- 10. • Next, investors specify the desired probability of reaching the threshold of each goal, say 99 percent for retirement income, 60 percent for college funds, and 20 percent for getting rich. Each mental account is now optimized as a sub- portfolio by the rules of mean-variance theory, and each feasible goal is achieved with a combination of assets.
- 11. • For example, the retirement goal is likely to be weighted toward bonds, the college goal is Likely to be achieved in a sub portfolio with a balanced combination of stocks and bonds, and the getting rich goal is likely to be Achieved in a sub-portfolio with a Combination weighted toward stocks, Perhaps with some options and lottery tickets thrown in
- 12. • The overall portfolio is the sum of the mental account sub- portfolios, and it, like the mental account sub-portfolios, lies on the mean-variance efficient frontier.