Behavioral biases can and should be accounted for by investors and their advisers in the investment policy development and asset allocation selection process.
Responses to such questions as the following may help develop the behavioral finance considerations that have an impact on investment decisions and the resulting portfolio.
- Which biases does the client show evidence of?
- Which bias type dominates (cognitive or emotional)?
- What effect do the client’s biases have on the asset allocation decision?
- What adjustment should be made to a “rational” (risk tolerance-based) asset allocation that can account for the client’s behavioral make-up?
- When should behavior be moderated to counteract the potentially negative effects of these biases on the investment decision-making process?
- When should asset allocations be created that adapt to the investor’s behavioral biases so the investor can comfortably abide by his or her asset allocation decisions?
- When is it appropriate to design a behaviorally modified asset allocation (referred to as a modified portfolio, for convenience) for an investor?
- Once the decision is made to recommend a modified portfolio, what quantitative parameters should be used when putting the recommendation into action
Goals-Based Investing (GBI)
Investment portfolios are managed and updated based on changing circumstances and goals of the client. This approach may be attractive to investors who are more focused on wealth preservation than on wealth accumulation.
GBI starts with establishing the relative importance to the client of each of the client’s goals.
- Essential needs and obligations should be identified and quantified first. These would include essential living expenses and should be met with low risk investments as the base layer of the portfolio assets.
- Next might come desired outcomes such as annual giving to charity which can be met with a layer of moderate risk investments.
- Finally low priority aspirations such as increasing the value of the portfolio to leave it to a foundation at death could be met with higher risk investments.
GBI is consistent with the concept of loss-aversion in prospect theory.
Behaviorally Modified Asset Allocation (BMAA)
BMAA is another approach to asset allocation that incorporates the client’s behavioral biases
BMAA considers whether it is better to moderate or adapt to the client’s biases in order to construct a portfolio the client can stick with. Moderating a bias attempts to reduce or eradicate the bias from the individual’s decision-making. Adapting to biases involves acknowledging the bias and adjusting for the bias rather than attempting to minimize or eliminate the bias.
Pompian and Longo (2005) offer two guidelines for helping a private wealth manager identify a behaviorally modified asset allocation for a client.
| Guideline I | The decision to moderate or adapt to a client’s behavioral biases during the asset allocation process depends fundamentally on the client’s level of wealth. Specifically, the wealthier the client, the more the practitioner should adapt to the client’s behavioral biases. The less wealthy, the more the practitioner should moderate a client’s biases. |
| Rationale | A client’s outliving his or her assets constitutes a far graver investment failure than a client’s inability to accumulate wealth. The likelihood of a client outliving his or her assets is a function of the level of wealth. If a bias is likely to endanger a client’s standard of living, moderating is an appropriate course of action. If a bias will only jeopardize the client’s standard of living if a highly unlikely event occurs, adapting may be more appropriate. However, the potential impact of low-probability, high-impact events should be discussed with the client. |
| Guideline II | The decision to moderate or adapt to a client’s behavioral biases during the asset allocation process depends fundamentally on the type of behavioral bias the client exhibits. Specifically, clients exhibiting cognitive errors should be moderated, and those exhibiting emotional biases should be adapted to. |
| Rationale | Because cognitive errors stem from faulty reasoning, better information and advice can often correct them. Conversely, emotional biases originate from feelings or intuition rather than conscious reasoning, and thus they are more difficult to correct. |
Visual Depiction of Guideline I and Guideline II
| Relative Wealth (RW) and SLR: | Biases Are Primarily: | Adapt to or Moderate the Biases of the Client: | Allowable Deviations Up or Down From Optimal Weight: |
|---|---|---|---|
| High RW and low SLR | Emotional | Adapt to | 10 to 15% |
| High RW and low SLR | Cognitive | Some of both | 5 to 10% |
| Low RW and high SLR | Emotional | Some of both | 5 to 10% |
| Low RW and high SLR | Cognitive | Moderate | 0 to 3% |