Investors like the idea of diversification, but they don't build portfo­lios in a manner suggested by portfolio theory. So how do investors build a diversified portfolio?

Your psychological tendencies cause you to think of your portfo­lios as a pyramid of assets.5 Each layer in the pyramid represents assets intended to meet a particular goal (see the pyramid depicted in Figure 9.6). You have a separate mental account for each investment goal, and you are willing to take different levels of risk for each goal. Thus you select investments for each mental account by finding assets that match the expected return and risk of the mental account.

First, you have a goal of safety. Therefore, you allocate enough assets in the safest layer (bottom of pyramid) to satisfy your mental accounts. Then mental accounts with higher levels of expected return and risk tolerance can be satisfied by allocating assets to the appropriate investments in another layer. For example, investors in retirement have need for investment income. The income goal is met in a layer of the pyramid with assets invested in bonds and high-dividend-paying stocks. After the income goal is met, the retiree may have the goal of keeping up with inflation. This investor would then have a set of assets in a layer that invests for growth.

Each mental account has an amount of money designated for its particular investment goal. The number of mental accounts requir­ing safety determines the amount of money placed in safe investments. On the other hand, some mental accounts designate "get-rich" assets. In sum, the total asset allocation of your portfolio is determined by how much money is designated for each asset class by your mental accounts. Some investors without many safety-oriented goals will have a greater amount of money placed in high-risk secu­rities. Other investors have many safety or income goals and there­fore have more securities in those layers of the pyramid.

The outcome is that portfolios are determined, formed, and changed because of the distribution of investment goals and associ­ated mental accounts. You have a tendency to overlook the interac­tion between mental accounts and between investment assets. Your diversification comes from investment goal diversification rather than from a purposeful asset diversification as described in Markowitz's portfolio theory.

SUMMING UP

In short, mental accounting causes you to misperceive the risk of individual securities. This leads to the formation of poorly diversified portfolios. As a consequence, you are taking too much risk for the level of expected return you are getting. Or, stated another way, you could obtain higher returns for the level of risk you are taking.