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Portfolio selection with mental accounts and background risk

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  • Baptista, Alexandre M.

Abstract

Das et al. (2010) develop a model where an investor divides his or her wealth among mental accounts with motives such as retirement and bequest. Nevertheless, the investor ends up selecting portfolios within mental accounts and an aggregate portfolio that lie on the mean–variance frontier. Importantly, they assume that the investor only faces portfolio risk. In practice, however, many individuals also face background risk. Accordingly, our paper expands upon theirs by considering the case where the investor faces background risk. Our contribution is threefold. First, we provide an analytical characterization of the existence and composition of the optimal portfolios within accounts and the aggregate portfolio. Second, we show that these portfolios lie away from the mean–variance frontier under fairly general conditions. Third, we find that the composition and location of such portfolios can differ notably from those of portfolios on the mean–variance frontier.

Suggested Citation

  • Baptista, Alexandre M., 2012. "Portfolio selection with mental accounts and background risk," Journal of Banking & Finance, Elsevier, vol. 36(4), pages 968-980.
    • Handle: RePEc:eee:jbfina:v:36:y:2012:i:4:p:968-980
    DOI: 10.1016/j.jbankfin.2011.10.015
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    References listed on IDEAS

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    3. Huang, Hung-Hsi & Wang, Ching-Ping, 2013. "Portfolio selection and portfolio frontier with background risk," The North American Journal of Economics and Finance, Elsevier, vol. 26(C), pages 177-196.
    4. Alexander, Gordon J. & Baptista, Alexandre M. & Yan, Shu, 2020. "Portfolio selection with mental accounts: An equilibrium model with endogenous risk aversion," Journal of Banking & Finance, Elsevier, vol. 110(C).
    5. Brandtner, Mario, 2018. "Expected Shortfall, spectral risk measures, and the aggravating effect of background risk, or: risk vulnerability and the problem of subadditivity," Journal of Banking & Finance, Elsevier, vol. 89(C), pages 138-149.
    6. Asgar Ali & K. N. Badhani, 2023. "Tail risk, beta anomaly, and demand for lottery: what explains cross-sectional variations in equity returns?," Empirical Economics, Springer, vol. 65(2), pages 775-804, August.
    7. Xu Guo & Raymond H. Chan & Wing-Keung Wong & Lixing Zhu, 2019. "Mean–variance, mean–VaR, and mean–CVaR models for portfolio selection with background risk," Risk Management, Palgrave Macmillan, vol. 21(2), pages 73-98, June.
    8. Hübner, Georges & Lejeune, Thomas, 2021. "Mental accounts with horizon and asymmetry preferences," Economic Modelling, Elsevier, vol. 103(C).
    9. Pfiffelmann, Marie & Roger, Tristan & Bourachnikova, Olga, 2016. "When Behavioral Portfolio Theory meets Markowitz theory," Economic Modelling, Elsevier, vol. 53(C), pages 419-435.
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    11. Xi Zhang & Xu Wu & Linlin Zhang & Zhonglu Chen, 2022. "The Evaluation of Mean-Detrended Cross-Correlation Analysis Portfolio Strategy for Multiple risk Assets," Evaluation Review, , vol. 46(2), pages 138-164, April.
    12. Jiang, Chonghui & Ma, Yongkai & An, Yunbi, 2013. "International portfolio selection with exchange rate risk: A behavioural portfolio theory perspective," Journal of Banking & Finance, Elsevier, vol. 37(2), pages 648-659.
    13. Brandtner, Mario & Kürsten, Wolfgang & Rischau, Robert, 2020. "Beyond expected utility: Subjective risk aversion and optimal portfolio choice under convex shortfall risk measures," European Journal of Operational Research, Elsevier, vol. 285(3), pages 1114-1126.
    14. Kuo-Hwa Chang & Michael Nayat Young, 2019. "Portfolios Optimizations of Behavioral Stocks with Perception Probability Weightings," Annals of Economics and Finance, Society for AEF, vol. 20(2), pages 817-845, November.
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    18. Huang, Xiaoxia & Di, Hao, 2016. "Uncertain portfolio selection with background risk," Applied Mathematics and Computation, Elsevier, vol. 276(C), pages 284-296.
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    More about this item

    Keywords

    Portfolio selection; Mental accounts; Background risk; Behavioral finance;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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