Behavioral Portfolio Theory and Investor Behavior

Behavioral finance offers unique insights into how investor behavior can impact financial decision-making and portfolio management. One notable concept within behavioral finance is Behavioral Portfolio Theory (BPT), which suggests that investors build portfolios to satisfy different goals rather than solely focusing on maximizing overall returns.

Consider the case of a hypothetical investor, Sarah, who is planning for her retirement. Sarah is risk-averse and divides her investments into three mental accounts: a low-risk account for her essential expenses in retirement, a moderate-risk account for lifestyle expenses, and a high-risk account for wealth accumulation beyond her retirement needs.

In your essay, discuss how Sarah’s investment behavior aligns with the principles of Behavioral Portfolio Theory. Include considerations of her risk preferences, the implications of mental accounting, and how this may affect portfolio construction and management strategies.