Journal of Financial and Quantitative Analysis

Research Article

Behavioral Portfolio Theory

Hersh Shefrin and Meir Statman*


We develop a positive behavioral portfolio theory (BPT) and explore its implications for portfolio constrution and security design. The optimal portfolios of BPT investors resemble combinations of bonds and lotterly tickets consistent with Friedman and Savage's (1948) observation. 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-SA). BPT-SA investors integrate their portfolios into a single mental account, while BPT-SA investors segregate their portfolios into several mental accounts. BPT-SA 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 poverth while the high aspiration layer is designed for a shot at riches.


* Both authors, Department of Finance, Leavey School of Business, Santa Clara University, santa Clara, CA 95053. We thank Enrique Arzac, Peter Bernstein, the late fisher Black, Werner De Bondt, Daniel Kahneman, Lola Lopes, Harry Markowitz, and Drazen Prelec for comments. We also thank Stephen Brown (the editor) and William Goetzmann (associate editor and referee) for construtive advice on how to shape the paper. This work was supported by the National Science Foundation, grant NSF SES-8709237, and the Dean Witter Foundation.