The Study Of Behavioral Factors In Optimal Portfolio Selection

Hossein Parsian

Department of Management, Qazvin Branch, Islamic Azad University, Qazvin, Iran

Hooshang Madani

Department of Management, Qazvin Branch, Islamic Azad University, Qazvin, Iran

Rashidoddin Rajabi

Islamic Azad University (IAU) – Arak Branch

Esmaill Beigiharchegani Sr.


December 20, 2015

Indian Journal of Fundamental and Applied Life Sciences, Vol. 5 (S4), 2015, pp. 779-786


The purpose of this study is specifying the role of behavioral finance in optimal portfolio selection. In this research accepted companies in Tehran Stock Exchange have been considered for 5 year period (from 2009 to 2013) and by examining 106 companies and using regression and analysis of variance techniques, the effect of behavioral factors in forms of mental accounting and loss aversion in investment stock on selecting the optimal portfolio with high efficiency is compared to standard finance. This research includes one main hypothesis and two sub hypotheses. According to this research the expected return of selected portfolio in behavioral model with an emphasis on mental accounting and loss aversion (as indicators of behavioral factors) has greater return than the standard model, so the result of research confirmed these hypotheses.

The Study Of Behavioral Factors In Optimal Portfolio Selection – Introduction

Fans of “behavioral finance” strongly believe that awareness of “psychological tendencies” in the field of investment is absolutely essential and have to be investigated further. For those who believe that psychology in financial knowledge has a crucial role in securities markets and investor’s decisions, having doubt about validity of behavioral finance is impossible. However, there are still so many academics and experts who are fans of “Financial classic” and not believe in behavioral aspects of human beings and their impact on financial decisions as an independent branch of study. But, the developments of qualitative and quantitative empirical researches in this area reflect the importance of behavioral research in financial markets, especially the capital market. In standard selection process of Portfolio, by determining the acceptable risk, limitations and purposes, the optimal values of assets in accordance with the standard model mean-variance were determined. As per human are exposed to behavioral biases, doing this process by human beings is impossible. For example, people who are exposed to changes in short-term and long-term trends of the shares, change their portfolios. Behavioral finance is a paradigm leading financial markets to be studied by considering models that considers two main assumptions which also limit the traditional paradigm and abandoned any try to interpret the behavior of investors as a psychological perspective. These two assumptions are: 1) The maximization of expected utility 2) Full rationality.

Literature Review

Theoretical Background

Portfolio selection and formation of assets portfolio have been a topic of discussion in financial theories and until the late twentieth century, in this area the majority of financial theories were discussed unsystematically. Markowitz (1952) presented the first stock portfolio theory in order to reduce the risk, evaluate the return of risky assets (model of Mean-Variance) and diversification of portfolio. This theory by assuming the equilibrium of a market results in the development of positive financial theories, such as capital market line of James (1958), capital asset pricing model of Sharp, Lintner and Black (1964), the hypotheses of efficient market by Eugene & Fama (1965) and options price modeling of by black and scholes (1973). In eightieth and ninetieth centuries, Amos Wersky, Daniel Kahneman and Richard Toler identified the irrational behavior of investors and presented the financial behavior theories. The dominant paradigm in financial theory is based on the maximization of expected utility and risk aversion. While empirical studies of real world in recent years have criticized the modern financial theories and the hypothesis of rational human beings, psychological studies are different from modern financial theories in description of rational human beings. Other investigations in financial field, such as scientific study of the behavior of stock prices suggest discrepancies in the facts and assumptions of the efficient market. Hence, financial academics who always attempt to recognize the financial market behavior and reason of different events, by using behavioral science intend to investigate the behavior of decision makers in the financial markets. Also, by designing the limitations of rational financial theories for explaining the facts, such as arbitrage restrictions and limitations of human cognitive, the factor of irrational behavior of human beings has been identified as an influencing factor on economic behavior along with other economic variables. In this present study, the impact of behavioral bias and its components on decisions of investors are examined.

History Research Studies

Until the early twentieth century, the psychology as a factor affecting the economic issues is ignored by neoclassical economists. The occurrence of multiple important events in decades of 1930s and 1950s formed the basis of behavioral economics. Development of “experimental economics”, make a doubt about the assumptions of economical human beings. Tversky and Kahneman by studying about making decisions in uncertainty conditions clarified the occurrence causes, reasons and effects of human errors in economical dialectics and presented the “prospect theory”.

Fernandez et al., (2009) classified behavioral biases into two groups of cognitive biases and emotional biases which both of them cause irrational behavior of human beings. Emotional biases like loss aversion are based on vision and sudden emotions and consequently it is not possible to reform them easily. Cognitive biases, such as availability of error rooted in argument method and getting the information leading to improvement and reducing the decision error. However, Shefrin showed that the portfolio selection with framework of “prospect theory” is different from portfolio selection in the framework of “expected utility theory”.

Kahneman and Tversky (1979 and 1992) investigated the new concept in financial behavior of investors to explain the “prospect theory” and new model of that called “cumulative prospect theory”. Investors make investment decisions based on profit and loss and it is not based on ultimate value of investments (mental accounting). People more dislike loss compared to pleasing with profit (risk aversion).

Optimal Portfolio Selection

Optimal Portfolio Selection

Optimal Portfolio Selection

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