What is Behavioral Portfolio Theory?

Behavioral portfolio theory (BPT) is a model that attempts to explain the impact of investor behavior on investment decisions and portfolio performance. The theory suggests that investors are not always rational and that their emotions can influence their investment decisions.

Behavioral portfolio theory has its roots in behavioral finance, which is a field of study that examines the role of psychology in financial decision-making. BPT was developed in an attempt to address some of the limitations of traditional financial theories, which assume that investors are rational beings who make decisions based on logical reasoning.

Behavioral portfolio theory, put forth by Shefrin and Statman in 2000, suggests that investors have varied aims and create an investment portfolio that meets a broad range of goals. It does not follow the same principles as the capital asset pricing model, modern portfolio theory and the arbitrage pricing theory.

A behavioral portfolio bears a strong resemblance to a pyramid with distinct layers. The base layer is devised in a way that it is meant to prevent financial disaster, whereas, the upper layer is devised to attempt to maximize returns, an attempt to provide a shot at becoming rich.

Investors are by nature emotional beings. We make decisions based on our feelings and biases rather than pure logic. This can often lead us astray when it comes to our finances. Behavioral finance is the study of how our emotions impact our investment decisions.

Many people invest without any real plan or goal in mind. They simply want to "beat the market." However, this is not a sound investing strategy. Investors need to take into account their own unique circumstances and risk tolerance when creating their portfolios. A well-diversified portfolio that meets your specific needs is much more important than trying to beat the market averages.

Behavioral portfolio theory suggests that investors are not always rational and that their emotions can influence their investment decisions. This can lead to suboptimal decisions that result in subpar performance.

BPT also has its roots in the work of Daniel Kahneman and Amos Tversky, who pioneered the study of cognitive biases in the 1970s. Their work showed that people often make decisions based on mental shortcuts, or heuristics, rather than logic. These heuristics can lead to suboptimal decision-making, and can cause people to act in ways that are contrary to their own best interests.

There are three main concepts in behavioral portfolio theory:

1) Cognitive biases

2) Emotional factors

3) Social factors

Cognitive biases are errors in judgment that occur due to how our brains process information. These biases can lead us to make suboptimal decisions when it comes to investing.

Emotional factors refer to the role that emotions play in investment decision-making. Our emotions can lead us to make impulsive decisions that we later regret.

Social factors refer to the role that other people play in our investment decision-making. We often look to others for guidance when making investment decisions, even though they may not have our best interests at heart.

While BPT has its roots in behavioral finance, it is a relatively new field of study with much still yet to be explored.

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If you are interested in learning about the more traditional and commonly used Modern Portfolio Theory you can read about it in our blog post here: https://blog.researchfin.ai/posts/what-is-behavioral-portfolio-theory