Behavioral Portfolio Theory (BPT)
Behavioral portfolio theory (BPT) is a behavioral finance theory that looks at how investors invest in practice. Unlike traditional finance, which assumes investors choose a diversified portfolio on the mean-variance efficient frontier, behavioral finance argues that investors construct their portfolios in layers.
On this page, we discuss the five-factor process that investors use under the behavioral portfolio theory model. This model was proposed by Shefrin and Statman in 2000 in a paper titled “Behavioral Portfolio Theory”.
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.
The five-factor process looks as follows:
- investor goals and importance of each goal is determined. This will dictate the allocation to each layer
- A high return goal will mean a high-return layer will be created
- Low risk goals will mean more funds are allocated to the low-risk layer
- 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
- 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
- If an investor thinks he or she has an information advantage, he or she will create more concentrated positions
- 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
BPT investors maximize wealth but with a constraint that wealth must have a low probability of falling below a certain arbitrary level. Investors will allocate to the low-risk layer to make sure they meet the aspirational level with low risk. Once that level is met, they can then afford to take more risk with the remaining portfolio. The overall portfolio may look diversified, but it will probably be sub-optimal because all the layers were built independently. Correlations are not taken into account.