Behavioral

FIN3399—
Special Topics in
Finance
Finance

Behavioral Finance

Winter Intersession
2022 Chapter 7 –
Behavioral
Dr. Hind Lebdaoui
Portfolio
 Behavioral Portfolios

Standard finance
Mean-variance portfolio theory (MVPT)

Behavioral finance
Behavioral portfolio theory (BPT)
 Standards Vs Behavioral
• The portfolio theory of standard
finance: Mean-variance portfolio
theory, described by Harry
Markowitz in 1952.
• Behavioral portfolio theory:
described in its initial form by Hersh
Shefrin and Meir Statman in 1987
and 2000
 Behavioral portfolios

Mean-Variance Portfolio Theory

1. Efficient portfolios are on the mean-variance frontier

Behavioral Portfolio Theory

1. Efficient portfolios are on the behavioral-wants frontier

 Behavioral portfolios

Mean-Variance Portfolio Theory

2. Portfolios on the mean-variance frontier satisfy

wants for utilitarian benefits (high expected returns
and low risk)

Behavioral Portfolio Theory

2. Portfolios on the behavioral-wants frontier satisfy wants

for utilitarian benefits, but also for expressive and
emotional, benefits (e.g. sincere social responsibility, high
social status)
What does the MVPF analysis tells
us:
Figure 8-1: A Mean-Variance Frontier and Portfolio C on the
Frontier
Expected
Returns

Portfolio C

Standard Deviation of Returns

Figure 8-2: A Mean-Variance Frontier and a Behavioral-Wants Frontier

Expected
Returns
Mean-Variance
Frontier

Portfolio E Behavioral
Wants Frontier
Portfolio F
3.72% Investment portfolios on the
behavioral-wants frontier are optimal
for investors who want the full range
of investment benefits: utilitarian,
expressive, and emotional
Current Portfolio D

Same risk level, lower than the optimal level

but satisfies management need of including
a wanted share, ensuring conformity to PF
convention

Standard Deviation of Returns

 Figure 8-3: A Nutrition-Cost Frontier and a Behavioral-Wants Frontier
Level of
Nutrition

nutrition-cost frontier
of diners who want Nutrition-Cost
only the utilitarian Frontier
benefits of food.
Stigler's Food
Nutrition Portfolio
Behavioral
for a Wants Frontier
Dietitians'
Moderatel
Food
y Active
Portfolio
Man
Weighing
154 lbs

$39.93 $100.00 Annual Cost

 Behavioral portfolios

Investors’ wants and the behavioral-wants frontier

• Wants for social responsibility

beliefs and values

• Wants for patriotism and familiarity

Home bias

• Wants for pride and avoidance of regret

Pride is an emotional benefit and regret is an emotional cost

• Wants for adherence to convention

To make palatable portfolios
 Behavioral portfolios

Investors’ wants and the behavioral-wants frontier

Wants for social responsibility

Exclusion of stocks of nuclear companies
from portfolios by socially responsible
investors is puzzling within mean-variance
portfolio theory.
 Figure 8-4: A Mean-Variance Frontier and a Behavioral-Wants Frontier
Satisfying Wants For Social Responsibility
Expected
Returns
Mean-Variance
Frontier

average
Opportunity
cost 3.00%

Behavioral Wants
Frontier Satisfying
Wants For Social
Responsibility

Not investing in nuclear companies

Not investing in non Sharia Compliant
stocsk

Standard Deviation of Returns

What do you think about this
investor.
• Think of buying a $30 share of stock and selling for
$1 a call option on that stock with an exercise
price of $40.

• What would you be gaining ?

• What would you be losing?
 Behavioral portfolios
Investors’ wants and the behavioral-wants frontier
Wants for pride and avoidance of regret: Pride is an emotional benefit
and regret is an emotional cost
Buying a $30 share of stock and selling for $1 a call option on that stock
with an exercise price of $40.
You enjoy one gain as you receive $1 for the option, which is the
“agreement money … that’s yours to keep forever.”
You enjoy a second gain as you collect the $2 dividend on the stock,
and a possible third gain as you collect the potential $10 increase in the
price of the share from $30 to $40.
The covered call’s potential loss, however, is obscured. You lose $60 of
potential profits if the share’s price zooms beyond $40 to $100.
 Behavioral portfolios

Investors’ wants and the behavioral-wants frontier

Wants for adherence to convention
• Some argue that mean-variance portfolios optimized
without constraints are unpalatable: imprecise estimates of
investment parameters lead to unpalatable extreme
allocations to stocks, bonds, gold, or other investments.
• Extreme allocations, however, are inherent in mean
variance efficient portfolios constructed with precise
estimates.
• convention might allocate to international stocks half of the
allocation to all stocks.
 Behavioral portfolios
Correcting cognitive and emotional errors
The roles of correlations and standard deviations in return gaps
& the benefits of diversification

Replacing Ignorance with Knowledge

Difficulty of replacing ignorance with knowledge
• Socioeconomic status: low socioeconomic status have no stock investments,
s hold more pessimistic beliefs about stock returns
• Misperceptions of benefits of portfolio diversification:
o High Financial literacy: diversification increases the expected returns of
portfolios
o Low Financial literacy: diversification increases the volatility of
portfolios.
• Errors related to correlation: Failure to consider correlations and
misperceptions of their role in the benefits of diversification are errors that
increase the risk of portfolios, imposing utilitarian costs without
compensating with utilitarian, expressive, and emotional benefits.
 Behavioral portfolios
Correcting cognitive and emotional errors
The roles of correlations and standard deviations in return gaps
& the benefits of diversification

Replacing Ignorance with Knowledge

Difficulty of replacing ignorance with knowledge
• Socioeconomic status: low socioeconomic status have no stock investments,
s hold more pessimistic beliefs about stock returns
• Misperceptions of benefits of portfolio diversification:
o High Financial literacy: diversification increases the expected returns of
portfolios
o Low Financial literacy: diversification increases the volatility of
portfolios.
• Errors related to correlation: Failure to consider correlations and
misperceptions of their role in the benefits of diversification are errors that
increase the risk of portfolios, imposing utilitarian costs without
compensating with utilitarian, expressive, and emotional benefits.
 Behavioral portfolios
Correcting cognitive and emotional errors
The roles of correlations and standard deviations in return gaps
& the benefits of diversification

Replacing Ignorance with Knowledge

• Errors related to correlation—

Question:

The expected return of a portfolio composed of two investments in equal

proportions is the 8 percent mean of the expected returns of the two
Calculate
investments. But the the expected
standard deviation of return
the returnsand risk of
of a portfolio the
composed
of two investments in equal proportions is less than the 30 percent mean of the
portfolio with 50%-50% allocation of each
standard deviations of the returns of the two investments. unless the
investment
correlation between their returns is a perfect 1.0
 Returns Gap
• Considering return gaps helps replacing ignorance with
knowledge about the role of correlations in the benefits of
diversification.
• return gaps: gaps between the returns of pairs of
investments such as US stocks and foreign stocks
• Return gaps serve as better measures of the benefits of
diversification than do correlations alone: accounting for
the effects of both: correlation and standard deviations.
• The gaps provide an intuitive yet accurate measure of the
benefits of diversification.
• return gaps and the associated benefits of diversification
are low when correlations are high, but return gaps and
the associated benefits of diversification are high when
standard deviations are high.
• The estimated return gap between the returns of two
assets is:
 Behavioral portfolios
Correcting cognitive and emotional errors
The roles of correlations and standard deviations in return gaps
& the benefits of diversification
Estimated Annual Return Gaps between Returns of Two Investments
with Varying Combinations of Correlation and Standard Deviation (The standard
deviation is the average of the standard deviations of the returns of the two
investments)

When is Diversification more useful, in a bear or bull market?

 Returns Gap
• The benefits of diversification are low when
correlations are high,
• but the benefits of diversification are high when
standard deviations are high.
• Contrary to common perceptions, the benefits of
diversification tended to be higher in bear than in
bull markets.
• While correlations tended to be higher in bear
markets than in bull markets, standard deviations also
tended to be higher in such markets and the higher
standard deviations in bear markets added to the
benefits of diversification more than the higher
correlations in bear markets subtracted from these
benefits.
 Note on Diversification
• The benefits of diversification disappear when correlations
between the returns of investments reach 1.0,
• So, correlations of 0.9 leaves little diversification benefits?
0.9 correlations and even 0.99 correlations provide
substantial diversification benefits.
• Benefits of diversification depend not only on the
correlations between the returns of investments but also
on their standard deviations.
• Low benefits of diversification when correlations are high,
• High benefits of diversification when standard deviations are high.
• Benefits of diversification tended to be higher in bear than
in bull markets (contrary to common perceptions).
• While correlations tended to be higher in bear markets
than in bull markets, standard deviations also tended to be
higher in such markets and the higher standard deviations in
bear markets added to the benefits of diversification more
than the higher correlations in bear markets subtracted
from these benefits
Behavioral portfolios— PF composition Segregation

Mean-Variance Portfolio Theory

3. Investors consider portfolios as a whole

Behavioral Portfolio Theory

3. Investors consider portfolios as layered pyramids, where

each layer is a mental account or "bucket" associated with a
want and goal
Figure 8-11: Behavioral-wants portfolios as pyramids of wants and
associated goals

Want and Associated Goal:

Upside Potential
Utilitarian Benefits:
Riches
Expressive and Emotional Benefits:
High social status and pride
(Stocks investments)

Want and Associated Goal:

Downside Protection
Utilitarian Benefits:
Protection from Poverty or
consumption constrained by poverty
Expressive and Emotional Benefits:
Financial independence and freedom
from fear
(Bonds?)
 Behavioral portfolios— Risk measures

Mean-Variance Portfolio Theory

4. Investors measure risk by the variance of returns

Behavioral Portfolio Theory

4. Investors measure risk by the probability of shortfall from

a goal, the amount of shortfall, or a combination of both
 Behavioral portfolios— Risk aversion(s)

Mean-Variance Portfolio Theory

5. Investors have a single risk aversion in their portfolio as a

whole

Behavioral Portfolio Theory

5. Investors have many risk aversions one for each mental

account
 Behavioral portfolios — Risk aversion & Risk(s)

Mean-Variance Portfolio Theory

6. Investors are always risk-averse, where risk is measured

by the variance of returns

Behavioral Portfolio Theory

6. Investors are always risk averse, where risk is measured

by the probability of shortfall from a goal, the amount of
shortfall, or a combination of both
 Behavioral portfolios

An investor with a target wealth of $100,000, a low

terminal wealth relative to his current $100,000
wealth

Investors with low target wealth relative to their

current wealth might find that a portfolio composed
solely of L (Lottery) is not on the behavioral-wants
frontier
Figure 8-13: Behavioral-wants portfolio with three wants and their
mental accounts – Retirement, education, and bequest

Bequest Want
Allocation: $50,000
Target Date: 25 Years
Target Annualized Return: 12%
Target Wealth: $650,003

Education Want
Allocation: $150,000
Target Date: 3 Years
Target Annualized Return: 8%
Target Wealth: $188,957
Retirement Want
Allocation: $800,000
Target Date: 15 Years
Target Annualized Return: 6%
Target Wealth: $1,917,247