IngentaConnect Chapter 10. Portfolios, Pyramids, Emotions, and Biases

Author: Shefrin, Hersh

Source: Beyond Greed and Fear, October 2002 , pp. 119-139(21)

Publisher: Oxford Scholarship Online Monographs

Abstract:

Harry Markowitz, the pioneer of modern portfolio theory, developed the theory of mean-variance portfolios, one of the pillars of standard finance. But he also developed the basic ideas that underlie frame dependence and loss aversion. So, when it came time to choose his own retirement portfolio, which way did he play it? He played it the behavioral way. Most investors play it the behavioral way. Playing it the behavioral way means that they base their portfolio choices, not on mean-variance principles, but on frame dependence, heuristic-driven bias, and something called the emotional timeline. In this chapter I describe how these three elements together shape (1) the kinds of portfolios that investors choose; (2) the types of securities investors find attractive; (3) the relationship that investors form with financial advisors; and (4) the biases to which investors are subject. The combination of emotion and framing induces many investors to structure their portfolios as “layered pyramids.” This structure is especially important for issues of security design. A well-designed security must fit naturally into a layered pyramid. In this respect, the emotion of regret lies at the heart of the investor–advisor relationship. Notably, heuristic-driven bias inhibits investors from diversifying fully, and induces them to trade too frequently.

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