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Abstract

Certain practitioners experienced with advising wealthy individual investors have argued that Markowitz optimization for individuals is difficult to explain, implement, and maintain as long-term policy. Instead of portfolio optimization from Modern Portfolio Theory, these proposals use behavioral finance as the basis for asset allocation and encourage individuals to formally incorporate their cognitive biases, particularly “mental accounting,” into their personal investment policy. A recent proposal by Chhabra advocates using three separate portfolios, i.e. “buckets,” each with different risk and return characteristics, to correspond to how wealthy investors seem to think about their investments. The authors show that these behavioral approaches are sub-optimal, sometimes seriously so, and the buckets can work at cross purposes with each other. Compartmentalization can lead to poor tax results, sub-optimal diversification, and inefficient asset allocation.

TOPICS: Portfolio theory, portfolio construction, in wealth management, risk management