Revised Mental Accounting: A Behavioral Portfolio Selection

Portfolio selection is the science of efficient diversification of investments in order to obtain better performance. Conventional finance models are built based on the assumption of investor rationality, while in behavioral finance this belief is strictly challenged, and portfolios are recommended based on investor behavior. One of the most appreciated behavioral portfolio selection is called Mental Accounting (MA), which is believed to be mathematically equivalent with mean-variance efficient (MV) portfolios. However, using a data of Tehran Stock Exchange (TSE), we revealed that although it is a behavioral portfolio, its recommendations do not lie on the efficient frontier behaviorally. We propose a Revised Mental Accounting (RMA), which includes a behavioral definition of risk, and suggests portfolios that are behaviorally efficient. We also interviewed with a sample of active investors in TSE, and our results show that 1) the assumption of rationality does not apply to TSE investors, 2) in spite of MA assumptions, different methods of risk tolerance measurement do not converge generally, and 3) investors’ preferences for RMA are significantly higher than MA statistically. Finally, we present that in a same level of expected return RMA produces portfolios with a lower level of risk compared to MA.