Behavioral Portfolios

There is a fundamental difference in the way portfolios are viewed in traditional financial theories and the way in which they are viewed in behavioral finance.

At the technical level, a portfolio is nothing but a collection of investment instruments such as stocks, bonds, real estate, etc.

However, the purchase of these instruments and the method of choice amongst them is driven by a philosophy. It is this philosophy that varies wildly when we consider behavioral investing against traditional investing.

In this article, we will have a closer look at how these alternate theories look at portfolios.

How are Portfolios Viewed Differently?

The traditional finance theory related to portfolio management was given by Harry Markowitz. Harry Markowitz believed that portfolios are a collection of financial instruments that must be combined in such a way that their risk-return characteristics provide the desired return for the investor.

The risk was defined as a deviation from a fixed return.

It was assumed that higher risk would produce higher returns. The result was an efficient frontier. This was a curve that combined different types of combinations of financial instruments.

For instance, one point on the curve would denote 80% equity and 20% debt, whereas another could denote 50% equity and 50% debt. Each point on the frontier would provide the same risk-adjusted return to the investor.

Behavioral finance theory has a different take on portfolios. It does not look at portfolios as a collection of financial instruments.

Instead, it looks at portfolios as a means to an end. This means that those investors invest in portfolios only because they want to achieve certain real-life goals such as retirement, kids education, kids marriage, etc.

The portfolio is viewed as a pyramid with multiple layers. Each layer symbolizes a single goal, and every set of investments is made to make the desired goal possible.

In behavioral portfolios, the risk is not defined as a deviation from a mean. Instead, it is defined as a failure to meet a predefined goal.

The behavioral finance view of the portfolio has certain advantages, which have been described in the rest of the article.

Advantages of Behavioral Portfolios

Behavioral portfolios tend to take cultural preferences into account. This explains why different people in different parts of the world invest differently. The goals of an individual’s life are directly derived from the local culture. It does not take only money into account.

Instead, it takes time, physical fitness as well as knowledge into question as well. In some cultures splurging on your everyday needs is idolized, whereas, in other cultures, it is considered foolish. This is the reason why goals and goal-based portfolios vary widely across the globe.

A behavioral portfolio is not based on abstract parameters. For instance, in most financial theories, it is assumed that investors are able to distinguish between a 70% probability of achieving a goal and a 50% probability of achieving a goal. However, in reality, this is not the case.

On the other hand, the assumptions for behavioral portfolio theory are deeply rooted in human behavior. This is because we all know that if human beings think honestly to themselves, they will be able to segregate a need that they have from want or a desire.

Also, they are perfectly capable of sequencing these desires and forming a pyramid to which they would want to allocate their funds. Hence, behavioral finance theory is more grounded in reality.

Traditional financial theory measures success in abstract terms. Successful investors are the ones who have derived the most utility from their actions.

An abstract unit of measure called “utils” is also used to measure the utility. Once again, this is not something that an average investor can relate to.

On the other hand, investors actually work hard to achieve certain goals such as social status, ability to provide for the family, etc. The success of these goals is more readily measurable as compared to abstract measurements in utils.

The behavioral pyramid mimics the way an actual human thinks.

  • For instance, the bottom layer in these pyramids symbolize actions which humans will have to take in order to avoid absolute poverty and financial ruin. Once those goals are secured, money is allocated to the next set of goals, such as education.

  • After that, money is allocated to investments and then to status symbols, etc. It provides human beings with an action plan about how they should be allocating their money based on their current financial situation.

  • It does not provide an abstract curve with different combinations of the risk-return value. Since this theory mimics human behavior in real life, it provides a more accurate depiction of how decision making is actually done. This provides more insights and helps investors make better decisions.

Behavioral from finance theory provides a better method of asset allocation. For instance, the money which is being saved for protection from poverty is allocated to bonds.

On the other hand, the money which is being saved for status symbols can be allocated to risky assets such as stocks. This is opposed to the traditional financial theory, where asset allocation is done purely on the basis of returns from the market. For instance, if stocks give a higher return, money which is saved for safety could also be diverted there!

The bottom line is that behavioral portfolio management provides an alternative to traditional portfolio management. Like all behavioral finance theories, this theory is more relatable and hence is more likely to be applied by investors.

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