Prescriptive portfolio selection: a compromise between fast and slow thinking

What is it about?

Portfolio selection is part of the finance literature that discusses asset choice and diversification to improve investor wealth. There are two streams of research in portfolio selection: conventional and behavioral. Despite conventional methods, behavioral portfolio theory as a part of behavioral finance does not consider the investor to be completely rational. The purpose of this paper is to develop a prescriptive portfolio selection (PPS) model based on a compromise between the idea of “fast” and “slow” thinking proposed by Kahneman. “Fast” thinking is effortless and comfortable for investors, while “slow” thinking may result in better performance. These two systems are related to the first two types of analysis in the decision theory: descriptive, normative and prescriptive analysis. However, to compromise between “fast” and “slow” thinking, overconfidence” is used as a weighting parameter. A case study including a sample of 161 active investors in Tehran Stock Exchange (TSE) is provided. Moreover, the feasibility and optimality of the model are discussed.

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Why is it important?

This is the first study that includes overconfidence, as a behavioral bias of investors, in modeling portfolio selection for the purpose of achieving a portfolio that has a reasonable performance and one that investors are comfortable with.

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