In Building Optimal Portfolios, Do Not Ignore Investors’ Emotions

Abstract

The field of behavioural finance points out various investor biases and heuristics which inhibit optimal investment choices and are sometimes deemed irrational. Although emotions are often viewed as anathema to sound financial decisions, there is a big emotional component that has to be taken into consideration when holistically defining financial goals. Investors have differing goals for investing. Portfolio theory should therefore not overlook these goals and its horizon should be expanded to offer investors with the best possible achievable solution by incorporating financially efficient anxiety reduction. A rational solution should therefore take investors’ behavioural shortcoming into account because investors do not simply care about risk-adjusted returns but the best returns that can be achieved for the level of stress they are going to have to endure over the volatile investment journey.

Keywords: Anxiety-Adjusted Returns, Goals-Based Investing, Loss Aversion, Mental Accounting, Prospect Theory

JEL Classification: G40, G41