ABSTRACT
The tools of traditional finance, like modern portfolio theory, can help investors establish efficient portfolios to maximize their wealth with acceptable levels of risk. However, mental accounting makes it difficult to implement these tools. Instead, investors use mental accounting to match different investing goals to different asset allocations. This often leads to investors diversifying their portfolios by goal rather than in total. When investors pick investments in each goal-focused mini portfolio, they examine each choice’s individual risk and return characteristics and ignore their diversification characteristics. They eliminate the choices they view as inferior and then often simply divide their money equally among the acceptable choices.
Even investors who overcome their tendency toward mental accounting and implement modern portfolio efficiency in their portfolios often find themselves second-guessing over time. The concept of integrating asset classes that exhibit a low correlation means that one or more asset classes held probably will be performing poorly at any given time. Even investors who believe in the diversification argument find themselves wanting out of the underperforming asset class in their portfolios.
