HOW TO APPLY BIAS DIAGNOSES WHEN STRUCTURING ASSET ALLOCATIONS

HOW TO APPLY BIAS DIAGNOSES WHEN STRUCTURING ASSET ALLOCATIONS

This section has been adapted from an article entitled “Incorporating Behavioral Finance into Your Practice,” which I, with my colleague John Longo, originally published in the March 2005 Journal of Financial Planning. It sets forth two principles for constructing a best practical allocation in light of client behavioral biases. These principles are not intended as prescriptive absolutes, but rather should be con- sulted along with other data on risk tolerance, financial goals, asset class preferences, and so on. The principles are general enough to fit al- most any client situation; however, exceptions can occur. Later on, some case studies provide a better sense of how these principles are ap- plied in practice.

To review, recall that when considering behavioral biases in asset al- location, financial advisors must first determine whether to moderate or to adapt to “irrational” client preferences. This basically involves weigh- ing the rewards of sustaining a calculated, profit-maximizing allocation against the outcome of potentially affronting the client, whose biases might position them to favor a different portfolio structure entirely. The

44 INTRODUCTION TO THE PRACTICAL APPLICATION OF BEHAVIORAL FINANCE

principles laid out in this section offer guidelines for resolving the puzzle “When to moderate, when to adapt?”

Principle I: Moderate Biases in Less-Wealthy Clients; Adapt to Biases in Wealthier Clients

A client outliving his or her assets constitutes a far graver investment fail- ure than a client’s inability to amass the greatest possible fortune. If an al- location performs poorly because it conforms, or adapts, too willingly to

a client’s biases, then a less-wealthy investor’s standard of living could be seriously jeopardized. The most financially secure clients, however, would likely continue to reside in the 99.9th socioeconomic percentile. In other words, if a biased allocation could put a client’s way of life at risk, moderating the bias is the best response. If only a highly unlikely event such as a market crash could threaten the client’s day-to-day security, then overcoming the potentially suboptimal impact of behavioral bias on portfolio returns becomes a lesser consideration. Adapting is, then, the appropriate course of action.

Principle II: Moderate Cognitive Biases; Adapt to Emotional Biases

Behavioral biases fall into two broad categories, cognitive and emotional, with both varieties yielding irrational judgments. Because cognitive biases stem from faulty reasoning, better information and advice can often cor- rect them. Conversely, because emotional biases originate from impulse or intuition rather than conscious calculations, they are difficult to rectify. Cognitive biases include heuristics (such as anchoring and adjustment), availability, and representativeness biases. Other cognitive biases include ambiguity aversion, self-attribution, and conservatism. Emotional biases include endowment, loss aversion, and self-control. These will be investi- gated as well as others in much more detail later on.

In some cases, heeding Principles I and II simultaneously yields a blended recommendation. For instance, a less-wealthy client with strong emotional biases should be both adapted to and moderated. Figure 3.1 il- lustrates this situation. Additionally, these principles reveal that two clients exhibiting the same biases should sometimes be advised differ- ently. (In Chapter 24, the hypothetical cases of Mrs. Adirondack, Mr.

Incorporating Investor Behavior into the Asset Allocation Process

High Level of Wealth (ADAPT)

Cognitive Biases Emotional Biases (MODERATE)

Low Level of Wealth (MODERATE)

FIGURE 3.1 Visual Depiction of Principles I and II Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, March 2005, M. Pompian and J. 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.

Boulder, and the Catskill Family will add clarity to this complex frame- work, while also illustrating how practitioners can apply Principles I and

II to determine the best practical allocation.)