FINANCIAL PORTFOLIO SELECTION: TRENDS AND CHALLENGES

Financial Portfolio Selection: Trends and Challenges

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FINANCIAL PORTFOLIO SELECTION: TRENDS AND CHALLENGES

Table of Contents

Introduction 3

Classes of Portfolios 3

Types of Portfolios 5

Statement of the Problem 9

Research Question 11

Contribution 11

Literature Review: Theoretical Background 11

Literature Review: Empirical Background 13

Conclusion 17

References 18

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The Implication of Behavioral Finance in Portfolio Selection

Introduction

A set of financial assets owned by a person collectively known as an investment portfolio

may comprise bonds, equities, currencies, cash and cash equivalents, and commodities.

Additionally, it describes a collection of investments that an investor makes to make money

while ensuring the preservation of cash or assets (Investment portfolio, 2022). Although there are

alternative possibilities, some persons and organizations manage their investment portfolios.

Many people decide to have their portfolios managed on their behalf by a financial adviser or

another financial expert (Gobler, 2022).

Asset classes are groups of assets that make up a portfolio. To preserve balance and

promote capital growth with minimal or managed risk, the financial adviser or investor has to

ensure a good combination of assets (Investment portfolio, 2022).

Classes of Portfolios

One of the classes of assets in stocks. A portfolio of investments often consists of stocks.

They refer to a division or part of a business. It denotes ownership of a portion of the corporation

by the stockholder. His ownership interest will vary in magnitude depending on how many

shares he has. Stocks are a form of income because, as a business produces profits, it distributes

a portion of those gains to its owners as dividends (Investment portfolio, 2022). Additionally,

depending on the firm's success, shares might be sold as they are purchased at a more excellent

price.

Another class of assets are bonds. Debt investments include bonds (Stobierski, 2022). An

investor who purchases bonds is making a loan to the bond issuer, which might be the

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government, a business, or an organization. The bond's terms specify its maturity date and the

interest rate that will be charged. A bond has a repayment period, which is the day on which the

original principal and accrued interest are to be repaid. Bonds provide less risk than stocks but

have fewer potential returns (Investment portfolio, 2022). Compared to stocks, bonds are often

considered less hazardous investment options. In other words, they stay the same value as often

as stock prices. As a result, bonds often do not provide the same potential for return (Stobierski,

2022).

Cash and cash equivalents and their counterparts are essentially identical to one another.

They are a part of a portfolio that includes cash, which can be both domestically and

internationally traded, and any other investment that can be quickly turned into cash, such as

certificates of deposit, money market funds, and short-term government bonds. While cash and

equivalents often provide little profit for a portfolio, they are essential. Cash availability covers

emergencies and enables investors to act quickly if an investment opportunity arises (Stobierski,

2022).

In some sense, portfolios themselves are funds. Individual investors contribute money to

funds, which subsequently make investments following their plan. For instance, a mutual fund

could invest in particular stocks, bonds, or other assets, possibly in a particular world area. An

exchange-traded fund (ETF) is intended to perform similarly to a particular index. Without

purchasing all the individual assets in a portfolio, funds may be an excellent method to get

exposure to various investment types (Stobierski, 2022).

An investment portfolio may also contain alternative assets. They might be things like

oil, real estate, and gold that have the potential to increase in value over time (Investment

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portfolio, 2022). Alternative investments are sometimes less liquid than standard assets like

stocks and bonds.

Types of Portfolios

Different types of portfolios exist depending on the investing techniques they employ. A

growth portfolio, also known as an aggressive portfolio, seeks to foster development by taking

bigger risks, such as investing in expanding sectors. Growth investment-focused portfolios often

have bigger potential returns but also higher potential risks. Instead of older, more established

businesses with proven track records, many growth investors choose to invest in younger

businesses that require funding and have space to expand (Gobler, 2022). Investing in new

companies with greater growth potential than larger, more established organizations is a common

practice in growth investing (Investment portfolio, 2022). Growth portfolio owners are prepared

to deal with short-term changes in the fundamental value of their investments if it increases the

likelihood of long-term financial gains. If investors wish to invest long-term or have a high-risk

tolerance, this form of the portfolio is suitable (Gobler, 2022).

Another type of portfolio is an income portfolio. An income portfolio, in general, is more

concerned with getting consistent income from assets than focusing on prospective financial

gains (Investment portfolio, 2022). Investors search for investments that give consistent

dividends with complex risks to the underlying value that generate those dividends rather than

those that could produce the most long-term financial gain. If investors are risk-averse or have a

short- to medium-term investment horizon, this portfolio style is perfect for them (Gobler, 2022).

An investor for value portfolios benefits from purchasing affordable assets by valuing

them. They are accommodating when the economy is struggling and many firms and investments

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have difficulty surviving. Investors then look for businesses that have the potential to make

money but are currently valued below what analysis would suggest is their fair market worth

(Investment portfolio, 2022). Value investing, in other words, focuses on locating deals in the

market. Investors with a value portfolio acquire stocks to keep them long-term with the objective

of long-term growth rather than concentrating on income-generating equities. This portfolio style

is perfect if investors have a medium tolerance for risk and a lengthy time horizon (Gobler,

2022).

Despite shifts in the larger market, a defensive stock offers comparatively low instability

in a sector or industry that tends to stay largely steady (Gobler, 2022). Defensive stocks, then, are

firms whose goods are consistently in demand, regardless of the status of the economy.

Low-volatility equities make up a defensive portfolio, which is designed to prevent losses

during a downturn in the market. As a result, risk and potential returns are frequently lower in

defensive strategies. In addition, these portfolios do better over the long term because they

provide slower but more consistent growth (Gobler, 2022).

Lastly, one of the choices that investors utilize the most frequently is a balanced

portfolio. This kind of portfolio's goal is to lower volatility. It mainly consists of income-

producing, moderate-growth companies and a sizable amount of bonds (Gobler, 2022). An

investor with a low to moderate tolerance for risk and a long-term time horizon should use this

portfolio.

Long-term financial planning is crucial for lifetime financial stability, but it is also quite

challenging for most investors. Earnings, savings, and investment decisions make up an

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investor's lifetime consumption and wealth. Therefore, investors must deal with portfolio issues

when choosing assets as they save for future consumption.

Retirement plan sponsors serve as both a gateway to the financial markets and a resource

for long-term planning for many investors. Plan sponsors must select, among other things, what

investment alternatives are available to participants, what advice is given to investors, and how

that information is customized for particular investors. A thorough comprehension of the

fundamental portfolio problem and knowledge of how investors make decisions are prerequisites

for providing appropriate guidance.

Traditional economic models presuppose that an investor has advanced analytical skills

and market knowledge. By implication, investors in these models select the best options and act

rationally. On how to define and address the issue that investors face, economists and even

seasoned investors may sometimes concur. However, ordinary investor has less attention and

time to dedicate to the issue than experts do, and they are less educated about it. It makes sense

that investors would use rules of thumb, show biases, or act in other irrational ways. This raises

difficulties for advisers and the typical investor, making ideal long-term financial planning

challenging.

How to help investors make the most significant financial decisions is a constant problem

for companies, financial advisors, and regulators. Financial advisers can increase investors'

lifetime financial stability by helping them make better decisions. On the other hand, investors

may be worse off if the advice is confusing or fails to consider their behavioral decision-making

processes. Understanding how investors absorb information and decide which investments to

make can help in portfolio selection.

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The goal of portfolio selection is to evaluate a group of securities out of the many options

that are accessible. It seeks to increase investors' returns on investments to the fullest. Investors

must choose between maximizing returns and minimizing risks, according to Markowitz (1952).

Investors have two options: either concentrate on risk minimization for a specified level of return

or maximize return for a degree of risk. Markowitz also computed investment return as the

projected value of securities' profits. Under Markowitz's definition, the risk is the deviation from

the estimated returns (Huang, 2006).

The study of behavioral Finance, which integrates psychology, economics, and other

social sciences to determine and comprehend why individuals make particular financial

decisions, can assist advisers in forging lasting bonds with their customers and creating

portfolios more suitable for their needs. Investors tend to make emotional, biased financial

judgments since they are human. Therefore, advisors may distinguish their services and

eventually provide better service to their customers by understanding the psychological or

emotional elements that cause investors to exhibit behavioral biases (de St. Paer, 2021).

Supporters of behavioral Finance are adamant that additional research must be done and

that understanding psychological tendencies in investing is necessary, especially in portfolio

selection. It is hard to question behavioral Finance's validity for those who think that psychology

in financial skills significantly influences the securities markets and investors' judgments.

However, many academics and professionals still subscribe to the financial classic. They do not

think that the behavioral characteristics of people and how they affect financial decisions should

be studied separately (Parsian et al., 2015). However, the evolution of quantitative and

qualitative empirical research in this field demonstrates the significance of behavioral Finance,

particularly the capital market. By identifying the acceptable risk, restrictions, and objectives, the

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optimal asset values in line with the standard model mean-variance were established in the

standard portfolio selection procedure. Humans cannot carry out this process since they are

subject to behavioral biases. This research focused on the behavioral finance section of

behavioral economics since it is believed that financial players are psychologically influenced

and have relatively normal and self-controlling inclinations rather than being rational and self-

controlled (Parsian et al., 2015).

Statement of the Problem

Making decisions is a skill for dealing with complicated situations. Selecting an option

from a range of potential alternatives is a cognitive process. One cannot just rely on their

resource while making a decision. The outcome might be a decision of action or a vision. Even if

making decisions without careful thought might be fair, they may not turn out well. By assessing

them, an investor's mental strategy mediates the various issues that arise at various stages.

Making decisions is the unique art of selecting one option from a range of accessible options. In

addition, it is a procedure that the alternatives adhere to after being carefully examined and

assessed. Investors who aim to succeed in a competitive business climate must keep up with a

variety of sectors in order to achieve their goals. It is crucial to realize that in the current fiercely

competitive global environment, investors must be able to maximize the returns on their

investments. Investors should also cultivate tenacity and a good outlook. Investors vary from one

another in a variety of ways and demographic characteristics, including socioeconomic status,

level of education, sex, race, and age (Jahanzeb et al., 2012). Few believe in greater risk for

greater reward, which is often harmful, while others feel that excellent safety comes from more

significant risk minimization.

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Therefore, choosing the specific region and subject of investment is the most challenging

element of the decision-making process. The ideal investment choice is given careful study.

Investors should take their tolerance for risk, rate of return, market circumstances, and other

restraints into account while building their investment portfolio (Jahanzeb et al., 2012). The

study of behavioral Finance demonstrates how various investors process information from the

market and respond to it. It is optional for all investors to act logically or to make objective

predictions using quantitative models. Because of this, behavioral Finance emphasizes how

investors' actions may cause a variety of market abnormalities. Due to its effects on how

investors perform, behavioral Finance has become an essential component of the decision-

making process. Investors may make smarter financial decisions and prevent repeating costly

errors in the future by using behavioral Finance. Risk has been classified into two major

categories by Ross et al. (2004). According to him, market movements of securities in an upward

or downward direction fall within the first group. The second category, in contrast, deals with

nonmarket risk, which is dependent on a company's fortune and that of the industry in question.

The selections made by investors deviate from the assumptions of economists, according to

Prospect Theory (Tversky, 1974), which they demonstrated using several studies. According to

Tversky (1974), investors often strive to avoid taking risks while the market is up, but they could

decide to take risks when it is down. The subject of this analytical investigation is how to

eliminate or reduce cognitive and psychological biases in the procedure of making investment

decisions.

Research Question

Does behavioral Finance have implications for portfolio selection?

Contribution

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According to experimental studies in behavioral Finance, investors frequently have little

processing capacity and low attentiveness. Additionally, there needs to be more disagreement on

how selection at risk is effectively conducted. Therefore, this study aims to define behavioral

Finance's function in selecting the optimal portfolio.

Literature Review

Theoretical Background

Financial theories have examined asset selection and portfolio creation; however, most of

these theories were systematically discussed in the latter half of the 20th century. Markowitz

introduced the first stock portfolio theory in 1952 with the goals of lowering risk, assessing the

return on hazardous assets, and diversifying a portfolio. Positive financial theories such as the

capital market line of Tobin (1958), the capital asset pricing model of Sharpe (1964) and Lintner

(1965), the efficient market hypothesis by Fama (1970), and the options price modeling of Black

and Scholes (1973) were developed as a result of this theory's assumption that a market is in

equilibrium.

Tversky (1974) uncovered investors' irrational conduct and put out the financial behavior

theories in the eighteenth and ninetieth centuries. The maximization of anticipated utility and risk

aversion are the cornerstones of the prevailing paradigm in financial theory. Psychological

studies diverge from current financial theories in their descriptions of reasonable human beings,

despite recent empirical investigations of the actual world criticizing modern financial theories

and the notion of rational human beings. According to other financial studies, such as a scientific

examination of stock price behavior, there are differences between the realities and presumptions

of the efficient market. In order to better understand financial market behavior and the causes of

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various occurrences, financial academics use behavioral science to look at how traders behave in

the financial markets. The component of irrational human conduct has also been found to

influence economic behavior and other economic factors by developing the arbitrage limits and

cognitive limitations of rational financial theories for explaining the facts. The current study

examines the effects of behavioral bias and its elements on investment decisions.

More studies in psychology were learning that individuals typically act in strange ways

while making judgments where money is involved. Psychologists have discovered that people

frequently behave irrationally while making economic decisions. For example, investors may

make poor financial judgments due to cognitive mistakes and strong emotions. The Capital Asset

Pricing Model, the Efficient Market Hypothesis, and other conventional financial theories did an

excellent job of foretelling and explaining certain occurrences, according to Shiller's theoretical

and empirical data (2003). However, academics began to notice abnormalities and behaviors that

these conventional theories could not account for. The January Effect, a financial market

anomaly where prices of securities rise in January without fundamental reasons (Rozeff &

Kinney, 1976), and The Winner's Curse, were winning big in an auction tends to exceed the

intrinsic value of the item purchased, primarily due to incomplete information and emotions

leading bidders to overestimate the item's value, are two examples that are frequently used

(Thaler, 1988). As a result, academics were motivated to resort to cognitive psychology to

account for irrational and illogical investor behavior (Parsian et al., 2015).

A relatively recent paradigm of Finance called behavioral Finance aims to complement

established theories of Finance by adding behavioral considerations to the decision-making

process. Some people regard the early proponents of behavioral Finance to be visionaries.

However, the discipline was validated by the 2002 Nobel Prize in Economics, given to

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experimental economist Vernon Smith and psychologist Daniel Kahneman. Smith used

experimental research to learn about alternative market mechanisms, whereas Kahneman

investigated human judgment and decision-making in the face of ambiguity. The fact that

psychologists were given the Nobel Prize for the first time was influential in persuading

traditional financial economists (Parsian et al., 2015).

Empirical Background

Neoclassical economists dismissed psychology as a factor influencing economic concerns

until the early twentieth century. The 1930s and 1950s saw several significant events that served

as the foundation for behavioral economics. Tversky clarified the incidence causes, reasons, and

effects of human errors in economical dialectics and presented the Prospect theory by studying

how to make decisions in uncertain situations. The development of Experimental Economics

casts doubts on the assumptions of economical humans (Jahanzeb et al., 2012).

In 2009, Fernandez et al. divided behavioral biases into cognitive biases and emotional

biases, both of which lead to illogical conduct in people. Loss aversion is an example of an

emotional bias dependent on vision and abrupt emotions, making it difficult to reform. Cognitive

biases like the availability of inaccuracy inherent in an argument's methodology and acquiring

knowledge that improves and reduces choice error. Shefrin and Statman (1994) demonstrated

that choosing a portfolio using the Prospect theory paradigm differs from choosing a portfolio

using the Anticipated Utility theory framework.

In their studies of the Prospect theory and its successor model, the Cumulative Prospect

theory, Tversky (1974) examined a novel idea in the financial behavior of investors. Investors do

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not base their judgments on the final worth of their assets; instead, they are focused on profit and

loss. Compared to being pleased with profit, people detest losing more.

Odin (1998) examined almost 10,000 investor trading accounts. His research revealed

that humans have a great propensity to recognize an advantageous payout. Additionally, Weber

and Camerer (1998) showed that consumers are more likely to sell shares that are more valuable

than their original purchase prices than those that are less valuable. Thaler and Johnson (1990)

offered a concept in which people grow more loss averse after experiencing a loss after

experiencing a profit over time. The influence of domestic money is what is meant by this.

Investors who start their day with gains are hesitant to take afternoon risks, according to Weber

and Zookhel (2005).

As a result, they avoided a potential loss and kept their prior profit. According to Shefrin

and Statman’s tendency phenomenon hypothesis (Shefrin & Statman, 1994), people hold onto

losing investments for a long time while quickly selling winning ones. The term fear of regret

describes this conduct. They demonstrated that people become less risk-averse after experiencing

a period of loss, and after experiencing success, they become more risk-averse. Asymmetrical

risk-taking is the term for this conduct.

A behavioral finance-based investment portfolio with levels of the pyramid was described by

Shefrin and Statman (1994). They asserted that by taking the investor's goal and the covariance

that exists between the levels into account, the choice of assets based on a structure of financial

behavior may be compared to pyramid layers. By taking into account the relationship between

risky and less risky assets, domestic bias, anticipated growth, and investor income, they could

explain the tiers of the proposed pyramid.

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In their study Prospect Theory, Mental Accounting, and Momentum, Grinblatt, and Han (2001)

considered investors' propensity to hold onto shares while their prices are falling. They realized

that this behavior is impacted by the perspective theory and mental accounting, which results in a

reduced response to news that a discrepancy between a stock's intrinsic worth and market value

has formed. Instead, the slow and haphazard growth of the intrinsic value and updating of the

reference point led to the convergence of these prices. As a result, expected equilibrium prices,

often known as "momentum," are produced.

In a study entitled " Bounded rationality as a source of loss aversion and optimism: A study of

psychological adaptation under incomplete information,” Yao and Li (2013) began investigating

the effects of bounded rationality on investors' psychological compatibility about making

decisions with insufficient information. They concentrated on whether loss aversion and future

profit optimism may result from constrained rationality. They began developing a model while

considering the psychological impact of this incident. They discovered that loss aversion

becomes compatible with optimism when the data are insufficient and that the evolution of these

two phenomena becomes substantial as the data get more distributed.

De Giorgi and Post initiated research on loss aversion when the reference point is a random

variable dependent on the mood or circumstance (2011) in their article titled "Loss Aversion

with Respect to the Reference Point depending on Situation." For instance, it defines a portfolio

manager who is assessed using a hazard indication rather than a fixed return. Expectations in this

framework are likewise influenced by the reference point, either adversely or positively.

Additionally, this structure avoids conventional aversion since there is no outcome, particularly

when the reference point and expectations are the same. They concluded that the point of

reference comprises an external, significant, and constant element. Additionally, they provided a

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FINANCIAL PORTFOLIO SELECTION: TRENDS AND CHALLENGES

model, in which costs are implemented towards an external reference point using Investment of

America data. They claim that this model can describe the diversification of bonds and stocks in

a wide range of assessment criteria, even though it goes beyond the historical background of

stock return towards bonds.

Five studies were used to demonstrate this in Ert and Erev's (2013) paper, "On the descriptive

value of loss aversion in decisions under risk: Six clarifications." The findings demonstrate that a

pattern indicating loss aversion can only arise under specific circumstances. However, the short-

term experiments do not use this paradigm. Additionally, it did not appear in any of the ten main

long-term tests. Long-term tests have not revealed this trend. However, the tiny sample size

shows that under these conditions, betting in the small size sample (Pasian et al., 2015).

Conclusion

Because people are complex beings, behavioral Finance investigates how emotional, cognitive,

and psychological aspects affect portfolio selection. The elements from cognitive psychology,

sociology, and financial economics are combined into behavioral Finance, a branch of

experimental economics, to provide a significant model of investor behavior in financial markets.

Numerous studies have demonstrated that people make entirely illogical decisions; thus, the

characteristics of behavioral decision-making that systematically influence financial market

behavior are being highlighted more. The discrepancy between expected and actual investor

behavior can be explained in part by behavioral Finance. Advisors will need to concentrate on

behavioral wealth management components and have a more profound knowledge of how biases

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might affect clients' investing decisions in the face of increased market volatility. Integrating

behavioral Finance into portfolio selection is essential for improving client satisfaction,

developing client connections, keeping clients, and producing better results. While behavioral

Finance does not assert that every investor would experience a similar illusion, it does guide how

to prevent illusions that might affect decision-making, particularly when making investments.

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