Behavioral finance and the architecture of the asset management industry

Abstract The standard portfolio approach assumes that investors maximize expected utility, and that the Markowitz mean–variance standard portfolio optimization approach can be applied. Behavioral research, however, indicates that investors’ behavior with respect to risk or uncertainty is not consistent with expected utility. Notably, decision makers transform probabilities. Most of the academic literature integrating those aspects, however, focuses on so‐called financial market anomalies but does not focus on the structural impact those behavioral aspects might have, notably in terms of industrial organization of the asset management industry. This paper provides a survey of the asset management industry and argues that the architecture of the asset management industry is inconsistent with the standard expected utility framework. The origin of the industrial organization of the asset management industry stems from the convexity of the flow–performance relationship, which is due to prospect theory effects. The convexity of the flow–performance relationship explains the inflation of mutual funds and fund families, a phenomenon inconsistent with the Mutual Fund Separation Theorem.