While investors understand the principle of diversification, they don’t form portfolios in the manner suggested by portfolio theory developed by Harry Markowitz. How, then, do they build a diversified portfolio?
The psychological tendencies of investors prod them to build their portfolios as a pyramid of assets as shown below:
The salient features of the pyramid of behavioral portfolio are as follows:
1. Investors have several goals such as safety, income, and growth often in that sequence.
2. Each layer in the pyramid represents assets meant to meet a particular goal.
3. Investors have separate mental accounts for each investment goal and they are willing to assume different levels of risk for each goal.
4. The asset allocation of an investor’s portfolio is determined by the amount of money assigned to each asset class by the mental accounts.
5. Investors end up with a variety of mini-portfolios as they over look interactions among mental accounts and among investments assets.
6. Diversification stems from investor goal diversification, not from purposeful asset diversification as recommended by Markowitz’s portfolio theory. This means that most investors do not have efficient portfolios. They may be taking too much risk for the returns expected from their portfolio. Put differently, they can earn higher expected returns for the level of risk they are taking.
The shadow of the Past
Consider this bet on a coin toss: If it shows heads, you win Rs 100; if it shows tails you lose Rs 100. Would you accept this bet? Suppose you had won Rs 500 earlier. Now would you accept this bet? What if you had lost Rs 500 earlier? Would this make the bet look any different to you?
While the odds of winning the Rs 100 do not change in the different scenarios, many people will take the bet in one situation, but not in the other. Put differently people seem to consider a past outcome as a factor in evaluating a current risky decision. In general, people are willing it take more risk after earning gains and less risk after incurring losses. Experimental studies suggest a ‘house money effect’ a ‘snake bite effect’ and a ‘trying to break even effect’.
After experiencing a gain, people are willing to take more risk. After winning money in a gamble, mature gamblers somehow don’t fully consider the winning as their own and are hence are tempted to risk it in further gambles. Gamblers refer to this as the house money effect.
After incurring a loss, people are less inclined it take risk. This is sometimes referred to as the snake-bite or risk aversion effect. A loss is akin to a snake-bite that makes a person more cautious.
Losers, however, do not always shun risk. People often jump at the chance to recover their losses. This is referred to as trying to break-even effect. In fact this effect may be stronger than the snake bite effect. A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.
There are other ways in which what has happened in the past has a bearing on present decisions, actions, and beliefs. Some of the well known effects are the endowment effect, the status quo bias, and the avoidance of cognitive dissonance. The endowment effect says that people end to place greater value on what belongs to them relative to the value they would place on the same thing of it belonged to someone else. A concomitant tendency is to put too much emphasis on out of pocket expenses and too little on opportunity costs. Status quo bias implies that people are comfortable with the familiar and would like to keep things the way they have been. Cognitive dissonance arises when the person is struggling with two opposite ideas – I’m smart, but I’m not smart. Since cognitive dissonance is psychologically painful, people tend to reject information that conflicts with their positive image.