Journal of Investment Management
Vandenbroucke, J. and S. Das (2018), “On the behavioral sensitivities of mean-variance efficient portfolios”, Journal of Investment Management 16(4), pp. 1-15.
In a nutshell
Modern portfolio theory finds the optimal portfolio composition as the one that maximizes expected return subject to a variance constraint. In a famous publication of 2010 (“Portfolio Optimization with Mental Accounts”, Journal of Financial and Quantitative Analysis) the founding father of modern portfolio theory, Nobel laureate Harry Markowitz, together with some co-authors including Sanjiv Das, show that the optimal portfolio composition is confirmed if the constraint is re-formulated in behavioral terms. Specifically, replacing variance as a measure for risk by an imposed probability of not meeting a predefined return target is proven to be identical if returns follow a normal distribution.
The current publication extends this pioneering article by showing that equivalence continues to hold if also the reward is re-formulated in behavioral terms. This allows rephrasing the challenging and technical task of portfolio optimization into plain language.