QUANTITATIVE GUIDELINES FOR INCORPORATING BEHAVIORAL FINANCE IN ASSET ALLOCATION

To override the mean-variance optimizer is to depart from the strictly rational portfolio. The following is a recommended method for calculating the magnitude of an acceptable discretionary deviation from default of the mean-variance output allocation. Barring extensive client consulta- tion, a behaviorally adjusted allocation should not stray more than 20 percent from the mean-variance-optimized allocation. The rationale for

46 INTRODUCTION TO THE PRACTICAL APPLICATION OF BEHAVIORAL FINANCE

the 20 percent figure is that most investment policy statements permit discretionary asset class ranges of 10 percent in either direction. For ex- ample, if a prototype “balanced” portfolio comprises 60 percent equities and 40 percent fixed-income instruments, a practitioner could make rou- tine discretionary adjustments resulting in a 50 to 70 percent equities composition and a 30 to 50 percent fixed-income composition.

Given here is a basic algorithm for determining how sizable an adjustment could be implemented by an advisor without departing too drastically from the pertinent mean-variance-optimized allocation.

Method for Determining Appropriate Deviations from the Rational Portfolio

1. Subtract each bias-adjusted allocation from the mean-variance output.

2. Divide each mean-variance output by the difference obtained in Step 1. Take the absolute value.

3. Weight each percentage change by the mean-variance output base. Sum to determine bias adjustment factor.

Tables 3.1 and 3.2 show behaviorally modified allocations calculated for two hypothetical investors, Mr. Jones and the Adams Family. Neither client’s bias adjustment factor exceeds 20 percent.

SUMMARY OF PART ONE Congratulations! We have now completed Part One of this book. We in-

troduced the basics of behavioral finance, focusing on the aspects most relevant to individual wealth management. In Chapter 1, we reviewed some of the most important academic scholarship in modern behavioral finance. We also distinguished between micro- and macro-level applica- tions, reviewed the differences characterizing standard versus behav- ioralist camps, and discussed how incorporating insights from behavioral finance can enhance the private-client advisory relationship.

In Chapter 2, we traced the emergence of the modern behavioral finance discipline, beginning with its roots in the premodern era. We started with a review of the work by Adam Smith and continued our way

Incorporating Investor Behavior into the Asset Allocation Process

TABLE 3.1 Distance from Mean-Variance Output for Mr. Jones

Change in Change in Variance

Mean-

Behaviorally

Percent Percent Output

Adjusted

(Absolute (Weighted Recommendation Recommendation Variance Value)

7% 5% Fixed income

Bias Adjustment Factor = 20% Reprinted with permission by the Financial Planning Association, Journal of

Financial Planning, March 2005, Pompian and Longo, “Incorporating Behavioral Finance into Your Practice.” For more information on the Financial Planning Association, please visit www.fpanet.org or call 1-800-322-4237.

TABLE 3.2 Distance from Mean-Variance Output for the Adams Family

Change in Change in Variance

Mean-

Behaviorally

Percent Percent Output

Adjusted

(Absolute (Weighted Recommendation Recommendation Variance Value)

Allocation

Average)

Equities 15 10 5 33% 5% Fixed income

Bias Adjustment Factor = 10% Reprinted with permission by the Financial Planning Association, Journal of

forward in time to cover Homo economicus and the dawn of the twenti- eth century. More influences on behavioral finance, which we also exam- ined, included studies in cognitive psychology and decision making under uncertainty. Here, we focused often on the contributions of Kahneman and Tversky, and of Kahneman and Riepe, as well as on psychographic modeling. We also looked at new developments in the practical application of behavioral finance micro.

48 INTRODUCTION TO THE PRACTICAL APPLICATION OF BEHAVIORAL FINANCE

Chapter 3 dealt with incorporating investor behavior into the asset allocation process. We discussed some of the limitations of risk tolerance questionnaires, introduced the concept of best practical allocation, and looked at methodology for diagnosing behavioral biases in clients. Of critical importance was our discussion of how detecting certain types of biases in particular types of clients might impact asset allocation deci- sions. The quantitative guidelines laid out for adjusting portfolio struc- ture comprised another key element of Chapter 3. We are now ready to move on to Part Two, which investigates specific investor biases as well as their implications in practice.

QUANTITATIVE GUIDELINES FOR INCORPORATING BEHAVIORAL FINANCE IN ASSET ALLOCATION