Conviction, diversification or something else: constructing optimal portfolios with additional attributes

Purpose - The purpose of this paper is to provide theory for some popular models and strategies used by practitioners in constructing optimal portfolios. King (2007), for example, advocated adding a diversification term to mean-variance problems to create better portfolios and provided clear empirical evidence that this is beneficial. Design/methodology/approach - The authors provide an analytical framework to help us understand different portfolio construction practices that may incorporate diversification and conviction strategies; this allows us to connect our analysis to ideas in psychophysics and behavioural finance. The critical psychological ideas are cognitive dissonance and entropy; the economics are based on expected utility theory. The empirical section uses the theory outlined and provides the basis for constructing such portfolios. Findings - The model presented allows the incorporation of different strategies within a mean-variance framework, ranging from diversification and conviction strategies to more ESG-oriented ones. The empirical analysis provides a practical application. Originality/value - To the best of the authors’ knowledge, this model is the first to bridge the gap between portfolio optimisation and the psychological ideas mentioned in a coherent analytical framework.