Hi,
i know these are related but unsure exactly the relationship between behavioral portfolio theory, mental accounting, and goal based investing. Is behavioral portfolio theory a theory which utilizes the mental accounting bias to explain how biased portfolios are formed? And then goal based investing is how an investment manager can accommodate the mental accounting bias?
thanks for any and all help…
Anyone know this?
My interpretation is BPT allocates assets to goals - an individual will have a high proportion of v low risk bonds it sees as retirement funding, and then another layer of high risk (spread betting account) which is for speculative gain.
Mental accounting involves separating the sources of wealth - current income, future income, income from assets. The consumption of these different sources differs:
Would appreciate if anyone has a better distinction between the two though!
I wouldnt consider them exclusive, BPT involves mental accounting. Mental accounting is the process of layering your investments with specific goals (i.e spend current income, do not touch retirement accounts etc). BPT is a methodology that incorporates mental accting in constructing the layers and importance of said layers, but goes further into the process by identifying utility functions and allocating accordinly. In the end, the portfolio will likely deviate from an efficient portfolio bc of mental accounting.
so, in summation, just as markowitz incorporates utility function into portfolio construction, bpt incorporates mental accting. GL mate
In my notes I noted that behavioral portfolio theory focuses on the differences between that and rational portfolio theory, where effects such as mental accounting take place.
I also noted that goals based investing is incorporated into behavioral portfolio theory, and that that and BPT helps to explain the polarization of risk characters in a portfolio by disregarding the covariance amongst the assets.
One of my undergrad paper was on behavioural finance, so I think I have a lot to say, and I will try to explain this in a systematic way.
Modern Portfolio Theory is a normative theory which suggests that a rational investor should maximize the utility function by invest in an efficient portfolio through diversification. Anything that prevents constructing such portfolio, such as mental accounting, are an irrational behaviour, and an rational investor won’t do that. However, the discovery of market anomalies, and those irrational behaviours that caused those anomalies contradicts the rational assumption of the Efficient Market Hypothesis. Thus, come the behaviouralists.
Theories and hypotheses developed by behaviouralists are mostly positive theories. Instead of telling you what an investor should do, Behavioural Portfolio Theory, Adaptive Market Hypothesis as well as other positive theories developed by behaviouralists, are trying to explain what the investors are actually doing and why are they doing. Maximizing the utility function was not even the concern in the Behavioural Finance realm, as it is in the Modern Finance realm. In fact, if you recall, the utility function was being replaced by the value function in the perspective theory, which most behavioural theories are based on.
Now here is the point where I sort disagree with CFA curriculum. Behavioural Portfolio Theory (as well as other behavioural theories) provides explanations, not guidances, to investment practices such as dividing your investment into different layers to meet your goals. Otherwise, they won’t be called positive theories. Behavioural investment practices, such as goal-based investing, predates the theories. Logically it make more senses to say that the theories were developed afterwards, to explain the phenomenon. (Because they are positive theories.) On the other hand, modern portfolio theories developed first, then follows the practice of utilizing the knowledge of efficient frontier, CAMP, diversification, etc, to construct a portfolio. (Because they are normative theories.) Some examples in CFA curriculum are trying to make the positive theories into normative, and to me, there are some problem with the methodology they are using, and especially, the logic seems flawed, but that’s for another time.
If I were to explain, the logic goes like this. Mental accounting were discovered as one of the causes of irrational investment behaviours, which cause market anomalies that shouldn’t have happened in an efficient market. The practice of goal-based investing has long existed and are considered irrational under modern finance. The behavioural portfolio theory explains that there is a reason for goal-based investing to exist; it’s not a matter of rational or irrational, as judged by whether the utility function is maximized, but rather, the value function is maximized because of goal-based investing.
As a note, Modern Portfolio Theory, along with Modigliani and Miller Propositions, and others are the dominant theories in Modern Finance. Together they make the school of Modern Finance. Whereas Behavioural portfolio theory and others are competing theories in Behavioural Finance. None of them had the dominance yet, which is one of the major reasons behavioural finance being criticized a lot by modern finance theorists such as Eugene Fama.
In short, two types of theories, two realms. Hope helps.