Mental Accounts -----Behavioral portfolio theory

Behavioral portfolio theory (BPT) of Shefrin and Statman (2000) says BPT investors do not consider their portfolios as a single set. Instead, BPT investors consider their portfolios as collections of mental account sub-portfolios where each sub-portfolio is associated with a goal and each goal has a threshold level. BPT investors care about the expected return of each sub-portfolio and its risk, measured by the probability of failing to reach the threshold level of return.

The integrated appealing features of MVT (Mean Variance Frontier---Markowitz) and BPT into a new mental accounting (MA) framework is needed. Features of the MA framework include an MA structure of portfolios, a definition of risk as the probability of failing to reach the threshold level in each mental account, and attitudes toward risk that vary by account. Once the investor specifies her sub-portfolio threshold levels and probabilities, the problem may be translated into a standard mean-variance problem with an implied risk-aversion coefficient. Aggregate portfolios composed of mean-variance efficient sub-portfolios are also mean-variance efficient.

So it is MVT, compartmentalised and to each compartment you apply the optimisation taking into consideration the risk mitigation factor or risk management factor or VAR into consideration. A retirement sub account or MA would mean lower probability to negative returns, while a speculative MA would provide some leeway to the negative shade of market reality.

The attitudes of risk taking actually varies and is a dynamic and not constant rational feature.

References:

1. Portfolio Optimization with Mental Accounts by Sanjiv Das, Harry Markowitz, Jonathan Scheid, and Meir Statman JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS Vol. 45, No. 2, Apr. 2010.

2. Markowitz, H.M. 1952a. “Portfolio Selection.” Journal of Finance, Vol. 7, no. 1 (March):77–91. 

3.Behavioral Portfolio Theory by Hersh Shefrin and Meir Statman, Department of Finance, Leavey School of Business,Santa Clara University.

Tapering - the event as it occurred.

I was always of the view that Bernanke would wait a wee bit longer to begin the so-called "tapering" exercise. So the postponement of the aforementioned event didn't come as a surprise to me, but infact my forecast/prediction worked well this time around.

Its the fragility of the US economy, which is indeed on steadier ground today, than earlier, but we all are aware that the sentimental swings these times are large and whimsical. Hence Bernanke wants to wait it out, watch some more stable economic information, before beginning to taper.

The Rickshaw insight!

With the fossil fuels unaffordable for the masses, I am one of the few who travel frequently by a rickshaw in Mumbai.

One of the days, I saw a unique psychological nuance.....or in other words...Human psychology at play.

On one of the Link Roads, my rickshaw was at the speed of about 40 - 50 km/h. There was a group of human beings waiting to cross the street. They waited and waited....until one of them gauged the speed of the rickshaw and jumped ahead to cross the street and was successful in his feat. What a revealing moment for the other group members, the "herd" jumped in and ran ahead to cross the street. Bringing then, the rickshaw to a halt.

Firstly, the first Mr. X took a long while to gauge the speed and then the "HERD" followed. The rational expectation would have been or move would have been to run across the street when rickshaw was far away. Infact all of them started running when the rickshaw approached close to them.

The HERD on the STREET phenomenon!!