The Pension Research Council
Working Paper

Behavioral Portfolios: Hope for Riches and Protection from Poverty

Meir Statman
WP2003-09

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Abstract

Behavioral portfolio theory is a useful description of the behavior of investors and a basis for good prescriptions. In particular, this theory posits that investors construct their portfolios as layered pyramids, where the bottom layers are designed for downside protection, while top layers are designed for upside potential. Risk-aversion gives way to risk-seeking at the uppermost layers as need to avoid poverty give way to hope for riches. Some investors fill the uppermost layers with the few stocks of an undiversified portfolio while others fill them with lottery tickets.

We might lament the fact that people are attracted to lotteries, or we might accept it and help people strike a balance between hope for riches and protection from poverty. This challenge faces governments that offer to their citizens both Social Security and lotteries, corporations that offer their employees both mutual funds and company stocks, and a financial services industry that offers its investors both bond funds and Internet stocks.