Behavioral portfolio theory:

Behavioral portfolio theory (BPT), put forth in 2000 by Shefrin and Statman, provides an alternative
to the assumption that the ultimate motivation for investors is the maximization of the value of their
portfolios. It 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. Each layer has well defined goals. 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.

BPT is a descriptive theory based on the SP/A theory of Lola Lopes (1987), and closely related to
Roy's safety-first criterion. The theory is described as a single account version: BPT-SA, which is very
closely related to the SP/A theory.In this multiple account version, investors can have fragmented
portfolios, just as we observe among investors. They even propose in their initial article a Cobb–
Douglas utility function that shows how money is allocated in the two mental accounts.

We compare the BPT efficient frontier with the mean-variance efficient frontier and show that, in
general, the two frontiers do not coincide. Optimal BPT portfolios are also different from optimal
CAPM portfolios. In particular, the CAPM two fund separation does not hold in BPT. We present BPT
in a single mental account version (BPT-SA) and a multiple mental account version (BPT-MA). BPT-SA
investors integrate their portfolios into a single mental account, while BPT-MA investors segregate
their port? folios into several mental accounts. BPT-MA portfolios resemble layered pyramids, where
layers are associated with aspirations. We explore a two-layer portfolio where the low aspiration
layer is designed to avoid poverty while the high aspiration layer is designed for a shot at riches.

BPT -SA

Similar to the mean-variance investors, the BPT-SA agents consider the portfolio as a whole but the
optimization criteria differ. The mean-variance efficient frontier is in (μ,σ) space where μ stands for
mean and σ stands for standard deviation. The mean variance frontier is obtained by maximizing μ
for fixed σ. In BPT-SA, the efficient frontier is in (En(W), Pr(W ≤ A)) space, where the first component
is related to the SP and the second one is related to A. Therefore, the BPT-SA frontier is obtained by
maximizing En(W) for fixed Pr(W ≤ A). Shefrin and Statman (2000) provide detailed solutions with
linear utility function and the CRRA utility function.

BPT-MA

Mental accounting is the characteristic that separates BPT-SA and BPT-MA. BPT-SA investors
integrate their portfolios by considering the covariances. BPT-MA investors overlook covariances and
segregate their portfolios into separate mental account layers. Mental accounting is a characteristic
of prospect theory. the decision process for the investors becomes complicated and difficult due to
covariance and other properties of joint probability distributions. Investors simplify their choices by
using mental accounts. Sometimes investors can be characterized only by a low or high aspiration
level. However, investors generally combine both because they want to avoid poverty and to have a
chance to become rich. Such portfolios combining low and high aspiration levels can be represented
by different mental account layers. The investors allocate some of their wealth in a lower layer, the
goal of which is to avoid poverty. They also allocate some of their wealth in a higher layer designed
to gain riches.