I.

Introduction
Behavioral portfolio theory (BPT) is developed as a positive portfolio theory on the foundation of
SP/A theory (Lopes (1987)) and prospect theory (Kahneman and Tversky (1979)), two hypotheses
of decision under vulnerability. Both SP/A hypothesis also, prospect hypothesis rose up out of the
writing tending to Friedman and Savage’s (1948) puzzle, the perception that individuals who
purchase insurance policies frequently purchase lottery tickets as well.
Markowitz’s (1952a) mean-difference portfolio hypothesis is one of three portfolio theories
presented in 1952 and the only one conflicting with the Friedman- Savage puzzle. On the other
hand, two other portfolio theories, named as Markowitz’s customary wealth theory and Roy’s
(1952) safety-first theory, are reliable with the puzzle. Indeed, customary wealth theory was
introduced by Markowitz (1952b) to deal with a few implausible ramifications of the Friedman –
Savage structure.
Further, efficient frontier is embedded within BPT. We look at the BPT efficient frontier with the
mean-difference efficient frontier and show that, in general, the two frontiers do not coincide;
portfolios on the BPT efficient frontier are generally not on the mean-variance efficient frontier.
By taking into consideration mean and variance, the mean-variance investors choose portfolios.
Whereas, by considering expected wealth, desire for security and potential, aspiration levels, and
probability of achieving aspiration levels the BPT investors choose the portfolios. There is a
difference between the optimal portfolios of BPT investors from those of CAPM investors. As in
CAPM, investors combine the market portfolio and the risk-free security. In comparison the BPT
investors resemble combinations of bonds and lottery tickets.

BPT

A single mental A multiple mental

account account

BPT-SA BPT-MA

Behavioral portfolio theory is presented in two versions: a single mental account BPT version
and a multiple mental account version. By considering covariance BPT-SA investors, like mean- variance
investors, integrate their portfolios into a single mental account. In contrast, BPT-MA investors segregate their
portfolios into mental accounts and overlook covariance among mental accounts. BPT-MA differs from both
Markowitz's mean-variance theory (1952a) and Markowitz's customary wealth theory
(1952b). For example, BPT-MA investors might place foreign stocks in one mental account and domestic
stocks in another. They might consider foreign stocks highly risky because they overlook the effect that
the covariance between foreign and domestic stocks exerts on the risk of the portfolio, viewed as an
integrated single account.

Now, we will review some of the theories which are as follows:

1. Safety-first Portfolio Theory

2. SP/A Theory: This will focus on the twin desires for security (S) and potential (O) and on the
aspiration levels associated with security and potential.
3. Portfolio Selection in BPT: We characterize the BPT-SA efficient frontier and show that, in
general, BPT-SA efficient portfolios are not mean-variance efficient.
4. The Character of Optimal BPT-SA Portfolios: describes the return distributions of efficient
BPT-SA portfolios.
Further, talking about Structural Issues concerning BPT portfolios. In particular, it tells that BPT-MA
portfolios are neither BPT-SA efficient in general, nor mean-variance efficient. Also, we will be
discussing about the comparison of real life portfolios to BPT portfolios. Lastly, emphasis is on the
conclusions we offer.

SAFETY FIRST PORTFOLIO THEORY

This theory was given by Roy in 1952. The main aim of this theory is to minimize the probability of ruin. Here the
investor is ruined if his terminal value falls short of a subsistence level.

In this theory, the author focuses on the case when there is no risk free security and the subsistence level is low.
So in this case when all portfolio return distributions are constrained to be normal, minimizing the probability of
ruin is equivalent to minimizing the number of standard deviations in which lies below mean return of the
portfolio.

So as per Roy’s theory, Being returns distributed normally, an investor chooses a portfolio to minimize the
function

s-mean(p)/sigma(p)

s- Subsistence level

p- portfolio

Sigma(p)- Standard deviation of portfolio p

Now if the returns are not normally distributed, the author uses Tchebyshev's inequality to argue that the same
objective function applies. His argument seems to imply that all optimal safety-first portfolios lie on the mean
variance frontier. However, we argue that this is not the case. In general, optimal safety-first portfolios are not
mean-variance efficient.

There are 2 generalizations of the theory that have been discussed by Elton and Gruber.
 1. Kataoka (Elton and Gruber)- Kataoka’s objective in the safety first theory is to maximize the subsistence
level to constraint that the probability that terminal value falls below the subsistence level does not
exceed a predetermined alpha.
2. Telser- He developed a model that features both a fixed subsistence level and probability of ruin. In his
model, a portfolio is considered safe if the probability of ruin does not exceed alpha. So in short he says
that
“Choose a portfolio to maximize terminal value subject to probability of ruin is < alpha”

Using the above formula we can calculate the SF ratio that is used by Roy in his theory.

The SFRatio provides a probability of getting a minimum-required return on a portfolio. An investor's optimal
decision is to choose the portfolio with the highest SFRatio. Investors can use the formula to calculate and
evaluate various scenarios involving different asset-class weights, different investments and other factors that
affect the probability of meeting their minimum return threshold.

SP/A Theory

In 1987, Lola Lopes developed the SP/A theory, SP/A stands for Security, Potential and Aspiration. This
theory gives you to understand how emotions impact on investor go assess risks while choosing among
risky prospects. This theory tells how people make their decisions when they involved in risky business.
In fact emotion provides mental energy which require for the particular action. SP/A theory mainly
focuses on how three emotions (Fear, Hope and Feeling of ambition) play their respective role while
choosing the portfolio. SP/A can be considerd as an extension part of Arzac’s version of safety portfolio
model. Lola Lopes try to define the purpose of SP/A theory as how a person can reach a specific target
goal on the basis of safety first concept. Potential can be relating to an ambition to reach big level of
wealth.

Arzac-Bawa and Telser models tell you when your wealth falls below a particular minimum level S can
be define as danger level. It defines the measurement of possibility of safety of prob{W>= s). This
probability is a DE cumulative probability, meaning that it has the form D(x) = Prob {W > x}: D is called
a DE cumulative distribution function.
In Lola lopes theory framework, there are two emotions which force to an individual take risk
willingness: fear and hope. Both emotions play crucial role simultaneously by altering the relative
weight. Lopes try to tell us that emotions of fear and hope you will get it within each and every
individual. She suggests that the final shape of the DE cumulative transformation function is a con? vex
combination of hs and hp, reflecting the relative strength of each.

PORTFOLIO SELECTION IN BPT

Behavioral portfolio theory is developed by conjugation of With Lopes’ SP/A theory and Kahneman-
Tversky’s theory. Building on SP/A, we start on single account version pf BPT and later in paper we
move towards multiple account version of BPT.

Consider at date zero market is in contingent claims, where consumption of one unit at date one is paid
by contingent claims of state i, and zero in other cases. Assume the price of state- i be vi., and let the
stated be ordered so stated price per unit probability vi/pi is decreasing in i. suppose tat the total wealth
with investor is Wo at a point in time and seeks to increase its wealth up to Eh(W) by purchasing claims
W1,…..,Wn whose value does not surpass Wo.

Theorem 1: W1,....Wn to

Has the form which is stated below. Also, there is subset T which represents states including sn which
represents the nth state as:

Summation in the previous equation is from one to n-1. There is a critical state ic if all the states of
equiprobable and the optimum portfolio has the form

Where summation is from one to n-1 and ic is the integer which has

Theorem 2: mean variance efficient portfolio has the following form in the discreate state case

b= positive constant
Proof: maximizing the expected quadratic utility results in efficient portfolio of mean-variance,

Which is subjected to constraints La-Grangean technique is used for constrained

maximum solution which presents the first order condition

Where is Lagrange multiplier. Solving for with budget constraint gives

Theorem 3: the portfolio is not a mean variance if there are three states that represent positive
consumption in BPT-SA efficient portfolio, with distinct values of vi/pi.

Proof : from theorem 2 we can say that :

Which is concave function of vi/pj , the price when probability is moralized. But optimal BPT-SA
portfolio is strictly increasing in i and have three payoff level one of which is zero.

THE CHARACTER OF OPTIMAL BPT SA PORTFOLIO

BPT SA investors choose optimal portfolios by maximizing the function

[Eh(W), D(A)]

Eh(W)- Expected Value of wealth under the transformed function.

D(A)- Probability that the payoff of the portfolio will A or higher (returns)

In fact, the criterion function used to evaluate alternative risky outcomes is a monotone increasing function
U(Eh(W),D(A)). The below theorem describes the return distribution of efficient BPT SA Portfolio.

Theorem 1 characterizes an efficient BPT-SA solution. We note that, for sufficiently high values of either A or a, it
will be impossible to satisfy the probability constraint and, therefore, no optimal solution will exist.

This portfolio return pattern corresponds to the return pattern of a combination risk-free bond that pays either A
or zero, and a lottery ticket that pays Wn - A in state sn and zero otherwise.

Lopes in 1987 shows the intuition underlying choice in SP/A framework through the choice of crops by farmers.
She notes that subsistence farmers often choose between two types of crops, food crops and cash crops. The
prices of food crops are low but generally stable. In contrast, the prices of cash crops are volatile, but they offer
the potential for higher wealth. Lopes notes that these farmers tend to plant food crops to the point where their
subsistence needs are met. Farmers allocate the remainder of their land to cash crops. She suggests that farmers
gamble on cash crops because they aspire to escape poverty.
In Lopes' framework, the fear of falling below subsistence motivates the allocation to food crops. This is the
safety-first approach. The aspiration of escaping poverty motivates the allocation of the remainder to cash crops.

In SP/A theory, risk is multidimensional, and is described with five parameters:

i) qs measures the strength of fear (need for security);

ii) qp measures the strength of hope (need for potential);

iii) A is the aspiration level;

iv) S determines the strength of fear relative to hope; and

v) 7, discussed below, determines the strength of the desire to reach the aspiration level relative to fear and
hope.

So by this we can see that the as the parameter d increases, it alters a mean variance investor’s optimal mean-
variance efficient portfolio. So this means that if there is any alteration in the above parameters, it alters that BPT
SA investors choice of portfolio.

Conclusion

We build up a positive behavioral portfolio (BPT) and investigated its implications for portfolio
development and security structure. Our model was presented in two versions as shown in the
structure above, BPT-SA, where the portfolio is incorporated into a single mental account and BPT-
MA, where the portfolio is segregated into multiple mental accounts, such that covariance among
mental accounts are overlooked. BPT investors, similar to the speculations in the Friedman-Savage
puzzle, are simultaneously risk averse and risk seeking; they both buy bonds and lottery tickets.

However, combination of bonds and lottery tickets resemble optimal securities for BPT investors. The
bonds for low aspiration mental account resemble risk-free or investment grade bonds, while the
speculative (junk) bonds are resembled by bonds for high aspiration mental account.

We plan to extend BPT in several ways.

 One extension involves the design of securities by corporations, especially in connection with
capital structure and dividend policy. Capital structure and dividend policy are usually approached
from the supply side; dividends are regarded as information signals and capital structure is
regarded as a solution to agency problems.
 We think that capital structure and dividend policy also need to be approached from the demand
side; corporate securities fit better than others into the layered pyramid structure
of BPT portfolios. Analysis of dividend policy requires a multi-period model.
  A multi-period BPT model is also useful for analyzing risk and its relationship to time
diversification. Proponents of time diversification argue that the risk of stocks declines as the time
horizon increases, while opponents argue that it does not (see Kritzman (1994)).
Lastly, the road from BPT will lead to an equilibrium asset pricing model, extending Shefrin and Statman
(1994), just as the road from mean-variance portfolio theory led to the CAPM