We develop a positive behavioral portfolio theory (BPT) and explore its implications for portfolio construction and security design. The optimal portfolios of BPT investors resemble combinations of bonds and lottery tickets, consistent with Friedman and Savage's (1948) observation. We compare the BPT efficient frontier with the mean-variance efficient frontier and show that, in general, the two frontiers do not coincide. Optimal BPT portfolios are also different from optimal CAPM portfolios. In particular, the CAPM twofund separation does not hold in BPT. We present BPT in a single mental account version (BPT-SA) and a multiple mental account version (BPT-MA). BPT-SA investors integrate their portfolios into a single mental account, while BPT-MA investors segregate their port? folios into several mental accounts. BPT-MA portfolios resemble layered pyramids, where layers are associated with aspirations. We explore a two-layer portfolio where the low aspiration layer is designed to avoid poverty while the high aspiration layer is designed for a shot at riches.

This paper develops a capital asset pricing theory in a market where noise traders interact with information traders. Noise traders are traders who commit cognitive errors while information traders are free of cognitive errors. The theory includes the determination of the mean-variance efficient frontier, the return on the market portfolio, the term structure, and option prices. The paper derives a necessary and sufficient condition for the existence of price efficiency in the presence of noise traders and analyzes the effects of noise traders on price efficiency, volatility, return anomalies, volume, and noise trader survival.

The well-known tendency of investors to favor cash dividends emerges quite naturally in two new theories of choice behavior [the theory of self-control due to Thaler and Shefrin (1981), and the version of prospect theory set out by Kahneman and Tversky (1979)]. Although our treatment is novel when viewed from the perspective of standard financial theory, it provides explanations for a phenomenon that has long been described as perplexing.

One of the most significant and unique features in Kahneman and Tversky's approach to choice under uncertainty is aversion to loss realization. This paper is concerned with two aspects of this feature. First, we place this behavior pattern into a wider theoretical framework concerning a general disposition to sell winners too early and hold losers too long. This framework includes other elements, namely mental accounting, regret aversion, self‐control, and tax considerations. Second, we discuss evidence which suggests that tax considerations alone cannot explain the observed patterns of loss and gain realization, and that the patterns are consistent with a combined effect of tax considerations and the three other elements of our framework. We also show that the concentration of loss realizations in December is not consistent with fully rational behavior, but is consistent with our theory.

Frank Milne, Hersh M. Shefrin; Clarifying Some Misconceptions About Stock Market Economies*, The Quarterly Journal of Economics, Volume 99, Issue 3, 1 Augu

The Cox, Ross, and Rubinstein binomial model is generalized to the multinomial case. Limits are investigated and shown to yield the Black-Scholes formula in the case of continuous sample paths for a wide variety of complete market structures. In the discontinuous case of Merton-type formula is shown to result, provided jump probabilities are replaced by their corresponding Arrow-Debreu prices.