Behavioral finance and portfolio management: Review of theory and literature

• Published date: 01 May 2020
• DOI: http://doi.org/10.1002/pa.1996
• Date: 01 May 2020
• Author: Anu Antony

PRACTITIONER PAPER

Behavioral finance and portfolio management: Review of

theory and literature

Anu Antony

Rajagiri College of Social Science, Rajagiri

Valley Campus, Kakkanad, Kochi, Kerala,

682039, India

Correspondence

Anu Antony, Assistant Professor, Rajagiri

College of Social Science, Rajagiri Valley

Campus, Kakkanad, Kochi, Kerala . PIN :

682039, India.

Email: anuantony@rajagiri.edu

Crowd psychology and cognitive biases are the outcomes of irrational behaviors.

Identifying the irrationality in the behavioral patterns can reduce the market anoma-

lies that we are facing in the stock market operations. Researchers have developed

the behavioral portfolio model, which is a prescriptive model by incorporating the

behavioral biases. The model was developed as an extension of capital asset pricing

model. The behavioral portfolio model explains why the investors invest with multi-

ple objectives such as future requirement of family, retirement saving, and fund for

meeting emergency. Application of behavioral finance will help in policy making pro-

cess by designing optimum portfolio and strategies to minimize the risk by controlling

the emotions of the investors.

JEL CLASSIFICATION

G4; G190; G100; G110

1|INTRODUCTION

Behavioral finance examines the impact of psychology on market par-

ticipants' behavior and the resulting outcomes in markets, focusing on

how individual investors make decisions: in particular, how they inter-

pret and act on specific information. Cognitive biases and affective

(emotional) aspects always contributed towards the decision making,

which is considered as irrational behavior. The researchers have

coined the irrational behavior into two groups: theory of cognitive

bias (Festinger, 1957) and prospect theory (Kahneman & Tversky,

1979). The cognitive theory postulates that behavior of an individual

is determined by his or her own mind, that is, contemplation and self-

perception determine both behavior and emotions (Beck, 2011). On

the other hand, the prospect theory describes how investors perceive

profit and loss. Value function was developed from prospect theory

based on experiments and empirical investigations (Kahneman &

Tversky, 1979). The value function states that people view gains and

losses differently and loss makes a greater emotional impact on inves-

tors than gain.

In the modern finance theory, behavioral finance is a new

paradigm, which seeks to appreciate and expect systematic financial

market influence of psychological decision making (Olsen, 1998).

Behavioral finance is an academic field that applies behavioral

concepts to the portfolio investment. It is an interdisciplinary

approach that incorporates insights from economics, psychology, and

sociology. However, in traditional financial theory, investors are con-

sidered to tend towards risk aversion at all times (Chou, Huang, &

Hsu, 2010).

There are mainly two theories relating the investors' behavioral

aspects:

1 Standard finance/Expected utility theory

2 Behavioral finance/Prospect theory.

Standard finance is a prescriptive theory built by Markowitz in

1952. Standard finance is the body of knowledge built on the pillars

of the arbitrage principles of Miller and Modigliani, the portfolio prin-

ciples of Markowitz, the capital asset pricing theory of Sharpe, Lintner,

and Black, and the option pricing theory of Black, Scholes, and Merton

(Statsman, 1999). Standard finance theory is designed to provide

mathematically elegant explanations of financial questions that are

often complicated. These approaches consider markets to be efficient

and are highly analytical and normative. And the theory focuses on

wealth maximization.

Received: 1 July 2019 Accepted: 2 July 2019

DOI: 10.1002/pa.1996

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