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Behavioral Portfolio Theory

by

Hersh Shefrin and Meir Statman Department of Finance Leavey School of Business Santa Clara University Santa Clara, CA 95053 Phone (408) 554-4385 email: hshefrin@mailer.scu.edu mstatman@mailer.scu.edu

November, 1997

We thank Peter Bernstein, Fischer Black, Werner De Bondt , Daniel Kahneman, Harry Markowitz, and Drazen Prelec for comments on a previous draft of this paper. This work was supported by the National Science Foundation, grant NSF SES - 8709237, and the Dean Witter Foundation.

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Behavioral Portfolio Theory

Abstract We develop a positive behavioral portfolio theory and explore its implications for portfolio construction and security design. Portfolios within the behavioral framework resemble layered pyramids. Layers are associated with distinct goals and covariances between layers are overlooked. We explore a simple two-layer portfolio. The downside protection layer is designed to prevent financial disaster. The upside potential layer is designed for a shot at becoming rich. Behavioral portfolio theory has predictions that are distinct from those of meanvariance portfolio theory. In particular, behavioral portfolio theory is consistent with the reluctance to have short and margined positions, an inverse relation between the bond/stock ratio and portfolio riskiness, the existence of the home bias, the use of labels such as “growth” and “income,” the preference for securities with floors on returns, and the purchase of lottery tickets.

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Behavioral Portfolio Theory

We develop behavioral portfolio theory as a descriptive theory, an alternative to the descriptive version of Markowitz's mean-variance portfolio theory. Behavioral portfolio theory links two issues, the construction of portfolios and the design of securities. Portfolios recommended by financial advisors, such as mutual fund companies, have a structure that is both common and very different from the structure of meanvariance portfolios...