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Portfolio Optimization with Mental Accounts

  • Das, Sanjiv
  • Markowitz, Harry
  • Scheid, Jonathan
  • Statman, Meir

We integrate appealing features of Markowitz’s mean-variance portfolio theory (MVT) and Shefrin and Statman’s behavioral portfolio theory (BPT) into a new mental accounting (MA) framework. 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. We demonstrate a mathematical equivalence between MVT, MA, and risk management using value at risk (VaR). The aggregate allocation across MA subportfolios is mean-variance efficient with short selling. Short-selling constraints on mental accounts impose very minor reductions in certainty equivalents, only if binding for the aggregate portfolio, offsetting utility losses from errors in specifying risk-aversion coefficients in MVT applications. These generalizations of MVT and BPT via a unified MA framework result in a fruitful connection between investor consumption goals and portfolio production.

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Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 45 (2010)
Issue (Month): 02 (April)
Pages: 311-334

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Handle: RePEc:cup:jfinqa:v:45:y:2010:i:02:p:311-334_00
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