On the Optimality of Behavioral Portfolio Construction Methods

In this article, we explore whether optimization methods proposed for the construction of CPT portfolios increase the chance of a representative investor to survive on his portfolio decisions and whether constructed behavioral portfolios are optimal for a rational investor. We evaluate the estimation methods that have been proposed in the literature for the estimation of CPT models and test their out-of-sample performance. We also establish the location of each estimation method on the efficient frontier of a rational and a behavioral investor. We report four main findings. First, CPT strategies generally exhibit both lower return and higher risk than the mean-variance investor. Second, while CPT strategies underperform the mean-variance strategy from a rational risk-adjusted return perspective, the CPT investors generally ‘believe’ that they outperform mean-variance investors due to their subjective evaluations. Third, the CPT strategies are not ‘optimal’ from a fully rational investor’s perspective with the exception of the HFR strategy. Similarly, the CPT strategies are not ‘optimal’ from a fully behavioral investor’s perspective with the exception of the QE strategy.