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Portfolio selection with mental accounts and background risk

  • Baptista, Alexandre M.

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.

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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 36 (2012)
Issue (Month): 4 ()
Pages: 968-980

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Handle: RePEc:eee:jbfina:v:36:y:2012:i:4:p:968-980
Contact details of provider: Web page: http://www.elsevier.com/locate/jbf

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  1. Alexander, Gordon J. & Baptista, Alexandre M., 2011. "Portfolio selection with mental accounts and delegation," Journal of Banking & Finance, Elsevier, vol. 35(10), pages 2637-2656, October.
  2. Gollier, Christian & Pratt, John W, 1996. "Risk Vulnerability and the Tempering Effect of Background Risk," Econometrica, Econometric Society, vol. 64(5), pages 1109-23, September.
  3. Laibson, David I. & Madrian, Brigitte C. & Choi, James J., 2009. "Mental Accounting in Portfolio Choice: Evidence from a Flypaper Effect," Scholarly Articles 4686774, Harvard University Department of Economics.
  4. Shefrin, Hersh & Statman, Meir, 2000. "Behavioral Portfolio Theory," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(02), pages 127-151, June.
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  6. Kimball, Miles S, 1993. "Standard Risk Aversion," Econometrica, Econometric Society, vol. 61(3), pages 589-611, May.
  7. Marjorie Flavin & Takashi Yamashita, 2002. "Owner-Occupied Housing and the Composition of the Household Portfolio," American Economic Review, American Economic Association, vol. 92(1), pages 345-362, March.
  8. Neal M. Stoughton & Youchang Wu & Josef Zechner, 2011. "Intermediated Investment Management," Journal of Finance, American Finance Association, vol. 66(3), pages 947-980, 06.
  9. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
  10. Merton, Robert C., 1972. "An Analytic Derivation of the Efficient Portfolio Frontier," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 7(04), pages 1851-1872, September.
  11. Heaton, John & Lucas, Deborah, 2000. "Portfolio Choice in the Presence of Background Risk," Economic Journal, Royal Economic Society, vol. 110(460), pages 1-26, January.
  12. Baptista, Alexandre M., 2008. "Optimal delegated portfolio management with background risk," Journal of Banking & Finance, Elsevier, vol. 32(6), pages 977-985, June.
  13. Jiang, Chonghui & Ma, Yongkai & An, Yunbi, 2010. "An analysis of portfolio selection with background risk," Journal of Banking & Finance, Elsevier, vol. 34(12), pages 3055-3060, December.
  14. Pratt, John W & Zeckhauser, Richard J, 1987. "Proper Risk Aversion," Econometrica, Econometric Society, vol. 55(1), pages 143-54, January.
  15. Das, Sanjiv & Markowitz, Harry & Scheid, Jonathan & Statman, Meir, 2010. "Portfolio Optimization with Mental Accounts," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 45(02), pages 311-334, April.
  16. Richard H. Thaler & Shlomo Benartzi, 2001. "Naive Diversification Strategies in Defined Contribution Saving Plans," American Economic Review, American Economic Association, vol. 91(1), pages 79-98, March.
  17. Gordon J. Alexander & Alexandre M. Baptista, 2004. "A Comparison of VaR and CVaR Constraints on Portfolio Selection with the Mean-Variance Model," Management Science, INFORMS, vol. 50(9), pages 1261-1273, September.
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