Understanding heuristics-based financial decision-making using behavioral portfolio strategies

Abstract

PurposeThrough a portfolio choice model, the study empirically examines the influence of the heuristic simplification through peak-end rule (PER) and the associated neglect of the duration of the experience. The portfolio strategy adopted involves optimizing portfolios to capture the impact of heuristic-driven investors' experience of good and bad states. The study attempts to validate PER in an empirical context and is expected to generate trading rules, which would exploit pricing errors emerging out of the use of heuristics by investors.Design/methodology/approachThe empirical approach adopted in the study primarily examines returns to portfolios sorted according to various hedonic evaluation rules. Behavioral portfolios are constructed using hedonic experiences as conditioning variables.FindingsThe results imply that there is continued investor demand for such assets in the short run. An equal weight portfolio based on a three-month hedonic evaluation earns an average monthly return of 2.77% over the next 12 months.Originality/valueThe authors’ study may perhaps be the first attempt to use the peak-end heuristic in portfolio construction.