Kremena Bachmann and Thorsten Hens INTRODUCTION Behavioral finance studies the psychological factors that influence financial behavior both at the level of the individual as well as at the level of the market. So far these results have been used mainly to explain the existence of patterns in asset prices and to develop investment strategies that exploit them.1 While these applications of behavioral finance aim to understand the market, this chapter focuses on the individual investors and asks how to help them to make optimal investment decisions. To give advice, one first needs to make a clear distinction between behavioral biases and behavioral preferences. Biases are deviations from rational behavior, while preferences are personal variants of rational behavior. As a rational benchmark we use expected utility and state-dominance. Measured against this benchmark, psychologically driven decisions are not always irrational. Moreover, they can be helpful in building realistic images of investors’ preferences, which is particularly important for decisions related to the optimal allocation of wealth. This chapter shows how to solve the asset allocation problems of investors without imposing restrictions on the distribution of asset returns while using realistic images of investors’ preferences. Within the suggested framework the attractive features of mean–variance analysis of Markowitz (1952) appear as a special case. Finally, this chapter analyzes the optimal investment behavior of investors over time and discusses the suitability of some well-known rules of thumb for investors with different preferences. While this chapter is based on recent results of our research group, which...
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