In today’s market, making the choice to invest is the easy part of the equation. Figuring out when to invest, with which company, and how (stocks, bonds, or any one of the multitude of acronyms vying for your dollar) requires deliberate decision-making, thorough research, and a rational mindset.

Enter: portfolio strategy.

Portfolio strategy encompasses the decisions that investors make as they attempt to preserve or grow wealth for the future.¹ Without strategy, investors can fall prey to behavioral fallacies and act irrationally, putting their money (and potentially, reputation) at risk.

Behavioral portfolio management (BPM) is a term that was first proposed by Thomas Howard, Professor of Finance at the University of Denver, in 2013. The concept proposes that most investors make their decisions according to heuristics and mental shortcuts.² 

BPM postulates that there are two types of investors:²

• Emotional crowds, or those who act according to anecdotal evidence and their emotions
• Behavioral data investors (BDIs), who navigate their financial choices according to sound data and thorough investigations 

This departs from previous theories. Modern portfolio theory (MPT), BPM’s antecedent, was the go-to theory for investment behavior in the 1970s. It suggested that, while many investors use emotion to drive decisions, most are rational.³ By virtue of being the majority, rational investors are able to rectify any potential pricing mistakes.3 Further investigations have revealed that this is not necessarily true, and that emotional investors frequently drive pricing.^{4, 5, 6} 

As an example, we can look to the Dot-Com bubble burst of 2000 or The Great Recession of 2008. If every investor were rational, then bubbles wouldn’t exist. In an ideal world, we would recognize the warning signs of a bubble and mitigate their harm.

Descriptions of bubbles and financial crises are really a play-by-play of highly emotional speculative processes. It’s actually predictable enough that researchers put together a five-stage journey:⁸

1. Patchy excitement
2. Euphoria
3. Anxiety and denial
4. Panic (when the bubble bursts)
5. Revulsion or shame

Sound portfolio strategy should strive to avoid loss aversion, which refers to our tendency to feel losses more strongly than equivalent gains.

Think about it: our level of sadness upon losing a $20 bill is higher than our level of happiness upon finding one in the street.

If left unchecked, this cognitive bias can lead investors to avoid investments with loss potential, even if the possibility of gains is greater.

Working together with Capital One, The Decision Lab created the Mind Over Money study to investigate how stress affects financial decisions. The study revealed that over three quarters of participants (77%) felt stressed about their current financial situation, and 58% reported feeling like money controls their lives. Under these stressful circumstances, people are less likely to save and budget, are more impulsive, and feel less control over their lives. 

Fortunately, the study also found that these negative feelings could be reversed when participants were encouraged to think about their long-term goals. This ‘bigger picture’ thinking made them more likely to budget and save, and feel more in control of their financial outlook.

1. Portfolio Strategy. (n.d.). Goldman Sachs. Retrieved September 6, 2022, from https://www.gsam.com/content/gsam/us/en/advisors/resources/portfolio-strategy.html#section-

2. Howard, C. T. (2014). Behavioral Portfolio Management. Journal of Behavioral Finance & Economics, Forthcoming. https://doi.org/10.2139/ssrn.2210032

3. Markowitz, H. M. (1959). Portfolio Selection. Yale University Press; JSTOR. http://www.jstor.org/stable/j.ctt1bh4c8h

4. Shiller, R. J. (1981). Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends? The American Economic Review, 71(3), 421–436.

5. Shiller, R. J. (2003). From Efficient Markets Theory to Behavioral Finance. Journal of Economic Perspectives, 17(1), 83–104. https://doi.org/10.1257/089533003321164967

6. Benartzi, S., & Thaler, R. H. (1995). Myopic Loss Aversion and the Equity Premium Puzzle*. The Quarterly Journal of Economics, 110(1), 73–92. https://doi.org/10.2307/2118511

7. Kenton, W. (2022, April 3). Bubble. Investopedia. https://www.investopedia.com/terms/b/bubble.asp

8. Taffler, R. (2018). Emotional finance: Investment and the unconscious. The European Journal of Finance, 24(7–8), 630–653. https://doi.org/10.1080/1351847X.2017.1369445