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.
