Behavioral Portfolio Theory (BPT)

Behavioral portfolio theory definition

First, let us discuss how BPT differs from traditional finance. Traditional finance assumes a diversified portfolio is chosen that satisfies the investor’s risk and return tolerance from a set of mean-variance efficient portfolios. The mean-variance efficient portfolio includes the risk-free asset and an allocation to the optimal portfolio as described by Markowitz. Investors are concerned with expected return and variance of the portfolio as a whole. 

Behavioral finance challenges this notion. Instead, BPT argues that investors construct their portfolios in layers. Each layer reflects different return and risk expectations. The investors’ goals are then used to allocate between the different layers. According to BPT, this is a five-factor process.

Five-factor process 

The five-factor process looks as follows:

1. investor goals and importance of each goal is determined. This will dictate the allocation to each layer
   1. A high return goal will mean a high-return layer will be created
   2. Low risk goals will mean more funds are allocated to the low-risk layer
2. Asset allocation is done by layer and based on the goal for that layer. If a high return is needed, more speculative assets will be added to that layer
3. The number of assets in each layer will depend on the investors’ risk aversion. If investors are risk-averse, the layers will contain more assets per layer
4. If an investor thinks he or she has an information advantage, he or she will create more concentrated positions
5. If the investor is risk-averse, he or she will hold larger cash positions to avoid the need to sell assets when liquidity is needed