PORTFOLIO OPTIMIZATION

GROUP 8: NIDHI MALLYA | ISHA

SUDAN | HARSH JAIN |
VEDANTAM GUPTA | RAHUL
SINGH | UDIT SHARMA
TABLE OF CONTENTS

INTRODUCTION………………………………………………………………………………………...3

SAFETY FIRST PORTFOLIO THEORY……………………………………………………………...5

SP/A THEORY……………………………………………………………………………………………7

PORTFOLIO SELECTION IN BPT……………………………………………………………………8

THE CHARACTER OF OPTIMAL BPT SA PORTFOLIO………………………………………...10

STRUCTURAL ISSUES………………………………………………………………………………...12

REAL WORLD PORTFOLIOS AND SECURITIES…………………………………………………………..13

CONCLUSION…………………………………………………………………………………………………….14

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INTRODUCTION

Behavioral portfolio theory (BPT) is developed as a positive portfolio theory on the foundation of SP/A
theory (Lopes (1987)) and prospect theory (Kahneman and Tversky (1979)), two hypotheses of decision
under vulnerability. Both SP/A hypothesis also, prospect hypothesis rose up out of the writing tending to
Friedman and Savage’s (1948) puzzle, the perception that individuals who purchase insurance policies
frequently purchase lottery tickets as well.
Markowitz’s (1952a) mean-difference portfolio hypothesis is one of three portfolio theories presented in
1952 and the only one conflicting with the Friedman- Savage puzzle. On the other hand, two other
portfolio theories, named as Markowitz’s customary wealth theory and Roy’s (1952) safety-first theory,
are reliable with the puzzle. Indeed, customary wealth theory was introduced by Markowitz (1952b) to
deal with a few implausible ramifications of the Friedman –Savage structure.

Further, efficient frontier is embedded within BPT. We look at the BPT efficient frontier with the mean-
difference efficient frontier and show that, in general, the two frontiers do not coincide; portfolios on the
BPT efficient frontier are generally not on the mean-variance efficient frontier. By taking into
consideration mean and variance, the mean-variance investors choose portfolios. Whereas, by
considering expected wealth, desire for security and potential, aspiration levels, and probability of
achieving aspiration levels the BPT investors choose the portfolios. There is a difference between the
optimal portfolios of BPT investors from those of CAPM investors. As in CAPM, investors combine the
market portfolio and the risk-free security. In comparison the BPT investors resemble combinations of
bonds and lottery tickets.

BPT

A single mental A multiple mental

account account

BPT-SA BPT-MA

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Behavioral portfolio theory is presented in two versions: a single mental account BPT version
and a multiple mental account version. By considering covariance BPT-SA investors, like mean- variance
investors, integrate their portfolios into a single mental account. In contrast, BPT-MA investors segregate
their portfolios into mental accounts and overlook covariance among mental accounts. BPT-MA differs
from both Markowitz's mean-variance theory (1952a) and Markowitz's customary wealth theory

(1952b). For example, BPT-MA investors might place foreign stocks in one mental account and domestic
stocks in another. They might consider foreign stocks highly risky because they overlook the effect that
the covariance between foreign and domestic stocks exerts on the risk of the portfolio, viewed as an
integrated single account.

Now, we will review some of the theories which are as follows:

1. Safety-first Portfolio Theory

2. SP/A Theory: This will focus on the twin desires for security (S) and potential (O) and on the
aspiration levels associated with security and potential.
3. Portfolio Selection in BPT: We characterize the BPT-SA efficient frontier and show that, in
general, BPT-SA efficient portfolios are not mean-variance efficient.
4. The Character of Optimal BPT-SA Portfolios: describes the return distributions of efficient
BPT-SA portfolios.

Further, talking about Structural Issues concerning BPT portfolios. In particular, it tells that BPT-MA
portfolios are neither BPT-SA efficient in general, nor mean-variance efficient. Also, we will be
discussing about the comparison of real life portfolios to BPT portfolios. Lastly, emphasis is on the
conclusions we offer.

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SAFETY FIRST PORTFOLIO THEORY

This theory was given by Roy in 1952. The main aim of this theory is to minimize the probability of ruin.
Here the investor is ruined if his terminal value falls short of a subsistence level.

In this theory, the author focuses on the case when there is no risk free security and the subsistence level
is low. So in this case when all portfolio return distributions are constrained to be normal, minimizing the
probability of ruin is equivalent to minimizing the number of standard deviations in which lies below
mean return of the portfolio.

So as per Roy’s theory, Being returns distributed normally, an investor chooses a portfolio to minimize
the function

s-mean(p)/sigma(p)

s- Subsistence level

p- portfolio

Sigma(p)- Standard deviation of portfolio p

Now if the returns are not normally distributed, the author uses Tchebyshev's inequality to argue that the
same objective function applies. His argument seems to imply that all optimal safety-first portfolios lie on
the mean variance frontier. However, we argue that this is not the case. In general, optimal safety-first
portfolios are not mean-variance efficient.

There are 2 generalizations of the theory that have been discussed by Elton and Gruber.

1. Kataoka (Elton and Gruber)- Kataoka’s objective in the safety first theory is to maximize the
subsistence level to constraint that the probability that terminal value falls below the subsistence
level does not exceed a predetermined alpha.
2. Telser- He developed a model that features both a fixed subsistence level and probability of ruin.
In his model, a portfolio is considered safe if the probability of ruin does not exceed alpha. So in
short he says that
“Choose a portfolio to maximize terminal value subject to probability of ruin is < alpha”

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Using the above formula we can calculate the SF ratio that is used by Roy in his theory.

The SFRatio provides a probability of getting a minimum-required return on a portfolio. An investor's

optimal decision is to choose the portfolio with the highest SFRatio. Investors can use the formula to
calculate and evaluate various scenarios involving different asset-class weights, different investments and
other factors that affect the probability of meeting their minimum return threshold.

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SP/A THEORY

In 1987, Lola Lopes developed the SP/A theory, SP/A stands for Security, Potential and Aspiration. This
theory gives you to understand how emotions impact on investor go assess risks while choosing among
risky prospects. This theory tells how people make their decisions when they involved in risky business.
In fact emotion provides mental energy which require for the particular action. SP/A theory mainly
focuses on how three emotions (Fear, Hope and Feeling of ambition) play their respective role while
choosing the portfolio. SP/A can be considerd as an extension part of Arzac’s version of safety portfolio
model. Lola Lopes try to define the purpose of SP/A theory as how a person can reach a specific target
goal on the basis of safety first concept. Potential can be relating to an ambition to reach big level of
wealth.

Arzac-Bawa and Telser models tell you when your wealth falls below a particular minimum level S can
be define as danger level. It defines the measurement of possibility of safety of prob{W>= s). This
probability is a DE cumulative probability, meaning that it has the form D(x) = Prob {W > x}: D is called
a DE cumulative distribution function.

In Lola lopes theory framework, there are two emotions which force to an individual take risk
willingness: fear and hope. Both emotions play crucial role simultaneously by altering the relative
weight. Lopes try to tell us that emotions of fear and hope you will get it within each and every
individual. She suggests that the final shape of the DE cumulative transformation function is a con? vex
combination of hs and hp, reflecting the relative strength of each.

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PORTFOLIO SELECTION IN BPT

Behavioral portfolio theory is developed by conjugation of With Lopes’ SP/A theory and Kahneman-
Tversky’s theory. Building on SP/A, we start on single account version pf BPT and later in paper we
move towards multiple account version of BPT.

Consider at date zero market is in contingent claims, where consumption of one unit at date one is paid
by contingent claims of state i, and zero in other cases. Assume the price of state- i be vi., and let the
stated be ordered so stated price per unit probability vi/pi is decreasing in i. suppose tat the total wealth
with investor is Wo at a point in time and seeks to increase its wealth up to Eh(W) by purchasing claims
W1,…..,Wn whose value does not surpass Wo.

Theorem 1: W1,....Wn to

Has the form which is stated below. Also, there is subset T which represents states including sn which
represents the nth state as:

Summation in the previous equation is from one to n-1. There is a critical state ic if all the states of
equiprobable and the optimum portfolio has the form

Where summation is from one to n-1 and ic is the integer which has

Theorem 2: mean variance efficient portfolio has the following form in the discreate state case

b= positive constant

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Proof: maximizing the expected quadratic utility results in efficient portfolio of mean-variance,

Which is subjected to constraints La-Grangean technique is used for constrained

maximum solution which presents the first order condition

Where is Lagrange multiplier. Solving for with budget constraint gives

Theorem 3: the portfolio is not a mean variance if there are three states that represent positive
consumption in BPT-SA efficient portfolio, with distinct values of vi/pi.

Proof : from theorem 2 we can say that :

Which is concave function of vi/pj , the price when probability is moralized. But optimal BPT-SA
portfolio is strictly increasing in i and have three payoff level one of which is zero.

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THE CHARACTER OF OPTIMAL BPT SA PORTFOLIO

BPT SA investors choose optimal portfolios by maximizing the function

[Eh(W), D(A)]

Eh(W)- Expected Value of wealth under the transformed function.

D(A)- Probability that the payoff of the portfolio will A or higher (returns)

In fact, the criterion function used to evaluate alternative risky outcomes is a monotone increasing
function U(Eh(W),D(A)). The below theorem describes the return distribution of efficient BPT SA
Portfolio.

Theorem 1 characterizes an efficient BPT-SA solution. We note that, for sufficiently high values of either
A or a, it will be impossible to satisfy the probability constraint and, therefore, no optimal solution will
exist.

This portfolio return pattern corresponds to the return pattern of a combination risk-free bond that pays
either A or zero, and a lottery ticket that pays Wn - A in state sn and zero otherwise.

Lopes in 1987 shows the intuition underlying choice in SP/A framework through the choice of crops by
farmers. She notes that subsistence farmers often choose between two types of crops, food crops and cash
crops. The prices of food crops are low but generally stable. In contrast, the prices of cash crops are
volatile, but they offer the potential for higher wealth. Lopes notes that these farmers tend to plant food
crops to the point where their subsistence needs are met. Farmers allocate the remainder of their land to
cash crops. She suggests that farmers gamble on cash crops because they aspire to escape poverty.

In Lopes' framework, the fear of falling below subsistence motivates the allocation to food crops. This is
the safety-first approach. The aspiration of escaping poverty motivates the allocation of the remainder to
cash crops.

In SP/A theory, risk is multidimensional, and is described with five parameters:

i) qs measures the strength of fear (need for security);

ii) qp measures the strength of hope (need for potential);

iii) A is the aspiration level;

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iv) S determines the strength of fear relative to hope; and

v) 7, discussed below, determines the strength of the desire to reach the aspiration level relative to
fear and hope.

So by this we can see that the as the parameter d increases, it alters a mean variance investor’s optimal
mean- variance efficient portfolio. So this means that if there is any alteration in the above parameters, it
alters that BPT SA investors choice of portfolio.

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STRUCTURAL ISSUES

A low aspiration doer and a high aspiration doer will have portfolios that compose of possibly risky
bonds and a lot of lottery tickets. But, no matter what happens, the low aspiration doer’s portfolio will
look more like a risk free bond s opposed to that of a high aspiration doer.

Any dollar claimed by a low aspiration doer will be assigned to the state Sn. A low aspiration doer makes
a choice based on the achieving positive claims. So basically, Us will be equal to max{Us, n-j}, for j=0
to n-1.

The allocation of a low aspiration doer is Ws,0 which he allocates to state Sn, and his aspiration is at
point As which is also low. So, this means that he will invest in less risky bonds in order to achieve
maximum utility.

On the other hand, a high aspiration doer will tend to use additional allocation Wr,0 and his aspiration
level will be at Ar which is above As. Such investors will focus on obtaining lottery tickets rather than
investing in riskless bonds. They have more hope when it coming to increasing payoffs in their accounts.

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REAL WORLD PORTFOLIOS AND SECURITIES

Real world portfolios are described as a design that is meant to meet the preferences of investors.
Bondholders generally receive face value at maturity, but those that hold lottery tickets usually receive
more than the usual coupon value. Lottery bonds with one coupon to maturity are mostly purchased at a
low aspiration level. Lottery bonds at a high state will have their face value increased by the high payoff
of the lottery ticket.

On the other hand, call options offer single size prizes. They offer prizes at different levels such as high
prizes, low prizes. Call options generally tend to appeal investors at different aspiration levels.

Treasury bills are designed for investors at low aspiration levels. Whereas equity participation is for those
who have a high aspiration level. Stock, call options, lottery tickets are for people who have a high
aspiration level.

The CMV puzzle highlights a pyramid which consists of cash at the bottom level, bonds at the middle
level, and stocks at the top level. As as investor goes from one level to another, his aggressiveness
increases along with his aspiration level.

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CONCLUSION

We build up a positive behavioral portfolio (BPT) and investigated its implications for portfolio
development and security structure. Our model was presented in two versions as shown in the structure
above, BPT-SA, where the portfolio is incorporated into a single mental account and BPT-MA, where the
portfolio is segregated into multiple mental accounts, such that covariance among mental accounts are
overlooked. BPT investors, similar to the speculations in the Friedman-Savage puzzle, are simultaneously
risk averse and risk seeking; they both buy bonds and lottery tickets.

However, combination of bonds and lottery tickets resemble optimal securities for BPT investors. The
bonds for low aspiration mental account resemble risk-free or investment grade bonds, while the
speculative (junk) bonds are resembled by bonds for high aspiration mental account.

We plan to extend BPT in several ways.

 One extension involves the design of securities by corporations, especially in connection with
capital structure and dividend policy. Capital structure and dividend policy are usually approached
from the supply side; dividends are regarded as information signals and capital structure is
regarded as a solution to agency problems.
 We think that capital structure and dividend policy also need to be approached from the demand
side; corporate securities fit better than others into the layered pyramid structure
of BPT portfolios. Analysis of dividend policy requires a multi-period model.
 A multi-period BPT model is also useful for analyzing risk and its relationship to time
diversification. Proponents of time diversification argue that the risk of stocks declines as the time
horizon increases, while opponents argue that it does not (see Kritzman (1994)).

Lastly, the road from BPT will lead to an equilibrium asset pricing model, extending Shefrin and Statman
(1994), just as the road from mean-variance portfolio theory led to the CAPM

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