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Contributions Pom plan

Incorporating Behavioral Finance into Your Practiceby Michael M . Pompian, CFA, CFP, andJohn M. Longo, Ph.D., CFA

MichaelM.Pompian, CFA, CFP"', is a wealthmanagem ent advisor at a global financial servicesfirm and is based in northern New Jersey. He advisesprivate clients in portfolio construction, financialplanning, and wealth transfer strategies.Mr.Pompianca n be reached at (888) 807-1753 [email protected].

JohnM. Longo, Ph.D., CFA, is chairman of theInvestment Committee at The MDE Group, aninvestment advisory firm. He is also a faculty memberin the Finance an d Economics Department at theRutgers Business School.Dr. Longo can be reached [email protected] or {609} 730-8281.

Mr.Pompian and Dr. Longo have published severalarticles on the subjea of practical application ofbehavioral finance.

F or many experienced wealth man-agement practitioners, the task ofcreating and delivering investmentsolutions to private clients cultivates both akeen awareness of "less than rational" deci-sion-making and a potential interest in thebranch of economicsbchin ioral financethat provides insights into irrationalinvestor behavior. AVhy. then, has therohust body of behavioral finance researchnot enjoyed mainstream application? Prac-titioners employ but a few ofthe signifi-cant number of investors' behavioral"biases"defined as systematic errors injudgmentthat have been identified byresearehers. Why nor more, and u hv have

Executive Summary Irrational investor behavior is com -

monly observed by wealth manage-ment practitioners when creating andadministering investment solutionsfor their private clients. Many advisorswould like to address behavioralissues, bu t lack diagnostic tools andapplication guidelines to employbehavioral finance research withclients.

Many clients would be well served byadjusting their asset allocations toaccount for biased behavior. By doingso, they w ould stand a be tter chanceof adhering to their investment pro-grams and enjoy be tter long-terminvestment results. In applying behavioral finance researchto client situations, practitioners mustdecide whether to attempt to changetheir clients' biased behavior or adapt

practitioners failed to consider behavioralbiases in the critici! duty of designing assetallocation programs for their clients.^ Theauthors offer two primary explanations forthis phenomenon, and contend that oncethese issues are resohed, behavioral financewill represent a new and \ ast frontier inseiTing clients.

First, behavioral biases, as presentlyarticulated, are not user-friendly becausethere is not a w idely accepted "industrystanda rd" m ethodology of identifv ing anindividual investor's biases. Researchershave done a significant amount of work toreveal behavioral biases, which are cer-

to it. Furthermore, quantitative guide-lines need to be available w hen m odi-fying asset allocations to account forbiased behavior.Practitioners should adapt to biases ahigh we alth levels and attemp t tomodify behavior at lower wealthlevels.They should adapt to emo tionabiases and moderate cognitive biasesThese actions will lead to a client'sbest practical allocation.Three case studies illustrate how theseguidelines are applied. A quantitativemode l is also unveiled tha t calculatesacceptable discretionary distances fromthe m ean-variance ou tput for deter-mining the best practical allocation.The article offers prac titioners aframework to better understand howbehavioral finance can be applied totheir individual clients.

tainlj- usable, l)ut practitioners would emously benefit from a comprehensivevolume, w hich does not prcsentl}' exisSecond, if an investor's behavioral biaseluivc been identified, practitioners lack guidelines necessar}' for incorporating tbiases during the process of de termininasset allocation.

Developing pR)per guidelines for inporating biases in as.set allocation deci-sionsthe focus


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Pompian Contributions

biases so that they can "fit" a pre-deter-mined asset allocation? (For purposes ofthis paper, we will call this moderatinga client.)

. When should advisors create asset allo-cations that ;uiapt ro clients' biases, sothat clients can comfortably abide bytheir asset allocation decisions? (Forpurposes of this paper, we will call this;u/;J/)f/ii^ to ,1 client.)

} . Once the decision is made to eithermoderate or adapt, what quanti tat iveparameters should be in place whenputting the moderate or adapt recom-mendation into action?These i|uestions u ill be explored, and

nvestor biases into account to create w ha the authors have termed the best practicallk)cation for a client. 'I hus equipped, prac-itioners may m ore easily and fruitfullyipply the body of behavioral finance

research.

Best Practical A llocatio nPracti t ioners are often vexed by theirl ients' decision-making process when i tomes to allocating their investment port-

folio. Let 's explore why this may happen.In designing a standard asset allocationprogram with a client , practi t ioners firstdminister a risk tolerance questionnaire,

then discuss the client's financial goalsnd constraints, and then typically recom-

mend the output of a mean-varianee opti-mization. Although this process maywork well for institutional investors, it

ften fails for individuals, who are suscep-tible to behavioral biases. In a commonscenario, a cl ient demands, in response tohort-term market movements and to theet r iment of the long- term investmentlan, that his or her asset allocation behanged.

Nobel prize-winner Daniel Kahnemannd co-author Mark Riepe (1998), who

have made significant contributions to

behavioral finance, describe financial advis-ing as "a prescriptive activity whose mainobjective should be to guide investors tomake decisions that serve their best inter-est."

Serving the best interest of the clientmay be the recom mendation of an assetallocation that suits the client's natural psy-chological preferences-and may not beone that maximizes expected return for agiven level of risk. More simplv, a client'sbest practical allocation may be a slightlyunder-performing long-term investmentprogram to which the client can comfort-ably adhere.

Conversely, another client's best practi-cal allocation may be one that goes againsthis or her natural psychological tendencies,and the client may be w ell-served to acceptmore risk than he or she might otherwisebe comfortable with to maximize returnfor a given level of risk.

Guidelines for D eterm iningBest Practical A llocationThe authors offer two propositions forguiding practitioners in identifying the bestpractical allocation for their clients whileconsidering behavioral biases:

Proposit ion I. The decision w hether tomoderate or adapt to a cl ient 's behavioralbiases during the asset allocation processdepends fundamentally on the client 'slevel of wealth. Specifically, the wealthierthe client , the more the practi t ionershould adapt to the client's behavioralbiases. Ihe less wealthy, the more thepracti t ioner should moderate a cl ient 'sbiases.

Rationale. A client's outliving his or herassets constitutes a far graver investmentfailure than a client's inability to am ass thegreatest possible fortune. In the formercase, the client's standard of living may bejeopardized; in the latter, the client's stan-dard ot living will remain in the 99.9' ' per-centile. In otlier words, if bias is likely to

endanger a client's standard of living, mod-erating is the hest c ourse of action. But ifonly an unlikely event, such as a marketcrash for those clients w ith market-basedwealth, could jeopardize the client's stan-dard of living, bias liecomes a lesser consid-eration, and adapting may be the moreappropriate action.

Proposition II. "Fhe decision u hether tomoderate or adapt to a client's behavioralbiases during the asset allocation processdepends fundamentally on the type ofbehavioral bias the client exhibits. Specifi-cally, clients exhib iting cognitive biasesshould be m oderated, w hiie those exhibit-ing emotional biases should be adapted to.

Rationale. Behavioral biases fall ititotwo broad categoriescognitive and emo-tionalthough both types yield irrationaldecisions. Because cognitive biases stemfrom faulty reasoning, better informationand advice can often correct them. (Con-versely, because emotional biases originatefrom impulsive feelings or intuitionrather than conscious reasoningthey aredifficult to correct. Cognitive biasesinclude heurist ics, such as anchoring andadjustment, availabil i ty, and representa-tiveness biases. (3ther cognitive biasesinclude selective memory and overconfi-dence. Kmotional biases include regret,lack of self-control, loss aversion, hind-sight, and denial. These biases will bedescribed in more detail in the next sec-tion of the paper.

Propositions I and II can, for someclients, yield a blended recomm endation.For instance, a less wealthy client w ithstrong emotional biases should be bothadapted to and moderated. Figure 1 illus-trates this concept. Additionally, clientsmay exhibit the same biases, but should headvised differently. 'I he cases of threehypothetical investors\ts. Smith, Mr.Jones, and the Adams familyw ill addclarity to these complexities, w hile illus-trating how praetitioners can apply thesepropositions to determine Itest practicalallocation.

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Contributions Pompian

High Level of Weaith(Adapt)

Cognitive Biases(Moderate)

Moderateand

I ^Moderate

r

1Adapt 1

Moderate Iand IAdapt 1

Emotional Biases(Adapt)

Low Levei of Wealth(Moderate)

Case StudiesCase A. Ms. Smith is a single 65-ye;ir-i)klv\ith a modest lifest\ 'Ic and no incomebeyond \\ hat her investment portfolio of$1 mill ion generates. Her j irinian' invest-

Helpful W eb SitesInvestor P ersonality Type Test-ing www.inve5torpsych.comJournal of Psychology and/Wcjr/cefswww.psychologyandmarket5.comJournal of Wealth t^anagem entwww.i i journals .com/JPPM/defaul t .aspMeir Statmanwww.lsb.5cu.eduRichard Thalerwww.gsb.uchicago.eduRobert Schil lerwww.econ.ya le .edu/Danie l Kahnem anwww . pr i nceton .eduUndiscovered Managers l isting ofbehavioral f inance researcherswww . undiscovered managers .com/Behavioralpercent20Finance2.htm

ment goal is to not outlive her assets: shedoes not, under any circumstances, wanttt) lose money because she recalls that herrelatives lost mone)- in the crash of 1929.Ms. Smith e.\hihits these hchavioralhiases: Loss aversion the tende ncy to feel the

pain of losses more than the pleasure ofy:ain Anchoring and ail justmentthe ten-dency to believe that current marketlevels are "right" by unevenly weightingrecent experience

Selective mem orythe tendency toreeall only events consistent with one'sunderstanding ofthe pastCase B. Mr. Jones is a single 50-\ear-old

pharmaceutical executive earning $250,000a year. H e lives extravagantly, occasionallyspending more than his income, but hassaved approximately $!..'' million. His pri-mar)- investment goal is to donate $.? mil-lion to his alma mater, but he cannot obtainlife insuran ce. M r. Jone s exhibits the fol-lowing biases:' Loss aversion Overconfidencethe tendency to over-

estimate one's investment savvy Lack of self-controlthe tendency to

spend today rather than save for tomor-ro wCase C. I he Adams family includes a

financially v\ ell-informed couple, both a36, and two children aged 4 and 6. Theyfinancially sound, but were not investedduring the hull market ofth e 19y()s as mof their neighbors were. The couple's totincome, $ 120,000, is, like the family itsenot expected to grow significanth'. I'hevhave saved $150,000, which they hope wbe the financial f{)undation from v\ hich u ill send their children to college and recomfortably. The Adams suffer from: Loss aversion Reg retth e tenden cy to feel deep d

appointment for having made incorrdecisions Availability biasthe tcnd enc\' to

believe that \\ hat is easily recalled ismore likeK'Furth er assume that it is 2001: capit

markets are off their highs (for stocks) alows (for bonds), but not yet at theextremes ofthe recent market cycle. Afyou, the practitioner, administer a risk terance i|uestionnaire, the mean-varianceoptimizer yields the follow ing allocationfor each ofthe three investors: Ms. Sm ith: 75 percent bonds, 15 per

cent stocks, 10 pcTccnt cash Mr. Jone s: H5 percent stocks, 10 perc

bonds. 5 percent cash I lie Adam s famiK': 70 perce nt stock

25 |>ercent bon ds, 5 perc ent cash1 hese case studies w ert- designed to hepractitioners ansv\ er three fundame ntalquestions:1. What effect do a client's biases have

the asset allocation decision?2. Should \ou moderate or adapt to the

biases??, What is the best practical allocation

each investor?

Solution to Case A: Ms . Sm it1. Effea of biases. .Ms. Smith's biases a

very consistent and lead to a clear alcation preference. Because Ms. Smitdoes not tolerate risk (loss aversion)

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Pom pi an Contributions

recalls tha t her relatives lost money(selective memory), she would naturallyprefer ;i safe and secure allocation.Additionally, .since the market hasdropped recentl) , she will likel\' makefaulty conciu.sions about current marketprices (anchoring antl adjustment); shewill be wary of any exposure to equi-ties. Thus, if you, as her advisor, pre-sented her with an allocation of 100 per-cent bonds, she would be likely toimmediately agree with that recommen-dation. However, you need to considerher liias toward such an allocation,. Moderate or adapt? Given .Ms. Smith'slc\L-! nf wealth, if you adapt to her biases,and recommend an allr>cation to I(K) per-cent Ixmds, your tlnancial planning soft-ware tells vou that Ms, Smith runs the

risk of outliving her assets, a clearly un ac-ceptable o utcom e. .Additionally, herbiases are principally cognitive (selectivememory, anchoring, and adjustment),and these types of biases can In; corrected\\ ith advice and information that w illhelp her understand that she would be atrisk if she accepted a 100 percent hondportfolio, f his being the case, the co rrectcourse ofaction is to moderate her biaspreferences and recommend that sheaccept some risk in her [njrtfolio. Yourrecommendation is to help her overcomeher behavioral biases and advise her to"fit" the slightl}- more aggressive alloca-tion the optimizer recommended.

3. Best practical allocation de cision. /\.s wehave decided to moderate Ms. Smith's!ii;ises, the best practical allocation is the

precise allocation that the mean-vari-ance optimix-er provided, 75 percentbonds, 15 percent stocks, 10 percentcash. You recommend this allocation toMs. Smith, andadminister a continuingprogram of investor education on therisk of outliving one's assets.

Solution toCase B: Mr. Jones1. Effect ofbiases. .\lr, Jones's biases do

not provide a clear indication of whatallocation he would naturally prefer. Onthe one hand, his overconfidcnce maylead him to be more comfortable withequities than is appropriate for him. Onthe other hand, because he does not tol-erate losses (loss aversion) and has a

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Contributions Pompian

Low Level of W ealth(Moderate)

Distance from Mean-Variance Output for Mr. Jones

Fixed IncomeEquitiesCash

MeanVarianceOutput1085

5too

BiasAdjustedAllocation Difference157510

100

- 510-5

Change in I Change inAbsolute ' WeightedValue AveragePercent : Percent50% ;12% I

100% \5%

10%5%

Bias Adjustm ent Factor =

Change InAbsoluteValuePercentChange InWeightedAveragePercent

high need for current income that sup-plements his "spend today" mentality(lack of self-control), he sees the benefitaffixed ineome investments. In thiscase, biases favoring fixed income out-u eigh those favoring equities, but fur-ther analysis is rei|uired.

2. Moderate or adapt? When consideringlevel of wealth, Mr. [ones clearK' does

Bias Adjustment Factor =

not run a standard-of-Hving risk. Addi-tionally, his behavioral biases are princi-pally emotional (loss aversion, lack ofself-eontrol). Given these two facts, andgiven that he naturally prefers an alloca-tion favoring fixed income, you decidethat indeed the appropriate recom men-dation is to adapt to his biases andcreate a less aggressive portfolio to

which he w ill be able to adhere andcomfortable with.

3. Best practical allocation decision. Thmcan-varunicc optimizer 's recom-mende d allocation was 85 percentstocks, H) percen t bo nds, 5 percent eUsing guidelines presented a later setion of this paper, "How Much to Merate or Adapt," your judgment is than allocation of 75 percent stocks, 15percent bonds, 10 percent cash is appriate. You also caution Mr. Jones thhi.s alma mater may receive $2.5 milversus his original goal of $3 million

Solution to Case C T h e AdamFamily1. Effect of biases. We are once again p

sented \\ ith biases that lead us in difent directions. Because the Adamsfamily's portfolio has not kept pace \tht'ir neighbors', the Adamses regrethaving made incorrect decisions in tpast, w hich may prompt them to takon more equity risk than may be appriate. But because they d(j not tolerrisk (loss aversion) and have shrunkfrom the latest information about th.skidding equity market (availabilirvOthey are more comfortable with lessexposure to equities. .Again in this cabiases favoring fixed income appear outweigh those favoring equitieswneed to thoughtfully consider the sition further.

2. Mode rate or adapt? The Adam s fambiases are mainly emotional (loss avsion, regret). Thus, your instinct is tadapt to a lower allocation to equitie50 percent V)ecause you believe that Adamses are likeK to be comfortablu ith, and be able to adhere to, such allocation. But given their level of\\ caltli, your financial plann ing softsuggests that a lower equity allocatiow ould not provide a secure retiremgiven their college expenses: that is.

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their stan dard of living is at stake. Youdecide to comprom ise, and your recom-mendation is to moderate and adapt,striking a balance between their invest-ment goal.s and biases.Best practical allocation decision. T h enican-variarice optimizer's recom-mended allocation was 70 percentstocks, 25 percent bonds, 5 percent cash.You had contemplated dropping theequity allocation to 50 percent ba.sed ontheir bia.ses, but realized that sucb anallocation would present a standard-of-living risk. Thus you bring the equityallocation up to 60 percent, whichresults in a compronii.se of 60 percentstocks, . 5 percent bonds, 5 percent cashallocation. You recommend this alloca-tion to the Adams family.Thes e case studies have dem onstrated

on u hile eonsidering2 supplements

1 by providing a visual desc ription

The decision to override the mean-varianceational" portfolio. The aut hors offer a

percent range is that most investmenta.s.s ranges of p lus or min us 10 per-

ple" balanced portfolio is defined as 60

es range from 50 [lercent toom 30 percen t to 50 percent.

Method for DeterminingAppropriate D eviations fromthe Rational Portfolio1. Subtract each bias-adjusted alloeation

from the mean-variance output.2. Divide each mean-variance output by

the difference. Take the absolute value.3. Weight each percentage change by the

mean-variance output base. Sum lodetermine bias adjustment factor.Tables I and 2 show the calculations

that justified the best practical allocationsfor M r. Jones and the Adam s Fam ily. Ms.Smith's bias-adjusted allocation did notdiffer from the mean-variance output; lierbias adjustment factor is 0 percent.

ConclusionThe propositions and cases presented hereprovide guidelines for practitioners toincorporate behavioral finance into assetallocation design to create what the authorshave termed the best practical allocation fora client. The authors undoubtedly believethat the future of advising private clientswill include behavioral fmance research,and the result will be that practitioners willbetter serve clients' best interests.

Endnote1. For purposes ofthis paper assume that

Mr. and M rs. Adams have a commonset of behavioral biases.

ReferencesDarst , D. 2003. The Art of Asset Alloca-

tion. Ne w York: McCIraw-Hill.Kahneman, I), and M. Riepe. 1998.

"Aspects of Investor Rsychology." /rx/

nal of Portfolio Ahinngemcnt. Summer :52-f>4.

Montier. j . 2002. Uchnvinnnil Finnncc:Insights inco Irnniomil M imls unJ .\hir-kets. West Sussex. England: yo/j/i Wiley& Sons Ltd.

Pompian, M. and J. Longo. 2004. "A NewParadigm for Practical Application ofBehavioral Finance: Creating Invest-ment Programs Itaseti on PersonalityType and Gender to Produce BetterInvestment Outcomes." Forthcoming inInstitiition.it Investor Journal of W'cAhhManagement. Fall: 9-15.Shefrin, H. 2000. Bvvond (irccd and Fear:Understanding Hchinionii limincc andthe Psychology of Investing. Boston,MA: Harvard Business Sch))ol Press.

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