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Writer's pictureSima Ohadi

When are two portfolios better than one? A prospect theory approach


Portfolio


Consider an investor receiving a performance report for their portfolio. It is highly likely that the portfolio contains both winning and losing assets. What would be the best way to present the portfolio’s performance—does the investor prefer these results to be aggregated or presented separately? In this article, we examine when and under what conditions presenting two portfolios might be preferable to presenting a single one.


Why is portfolio presentation so important? The answer lies in how we perceive and compare information. We tend to compare portfolio results with the market or with options and strategies we did not pursue. Such comparisons can lead to regret and emotional adjustments to the portfolio. Therefore, the idea is to minimize regret and its emotional effects by presenting portfolio performance differently.


In one of his 2018 interviews, Daniel Kahneman, author of Prospect Theory and Nobel laureate, proposed a "regret-proof policy": a behavioral portfolio policy with which an investor can cope when things go wrong. The idea is that investors have two portfolios: one risky and one safer, which are managed and reported separately.


In practice, investors usually have only one portfolio. However, having two portfolios can provide a sense of security, as at any given time, one of the portfolios is likely performing better than the market or the other portfolio.


In this article, we explore whether the presentation of portfolio performance matters and how Prospect Theory can explain people's preferences. To this end, we conducted an experimental survey in which we presented various portfolio presentations to individuals. Our findings reveal that individual preferences for portfolio result presentations align with the mental accounting proposed by Thaler (1985) and Thaler and Johnson (1990).


We also found that when the portfolio result is negative, presenting the portfolio separately with two mixed sub-portfolios (negative and positive) leads to greater satisfaction and better evaluations of the advisor. Satisfaction with a separate presentation is lower when the portfolio result is positive.


In general, we propose that separating results prevents individuals from fixating on a single outcome. The mechanism by which the regret-proof policy presentation works is by drawing attention to both gains and losses.






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