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Incorporating Behavioral Finance into Your Practice

by Michael M. Pompian, CFA, CFP®, and John M. Longo, Ph.D., CFA

Executive Summary
• Irrational investor behavior is commonly observed by wealth management practitioners when creating and administering investment solutions for their private clients. Many advisors would like to address behavioral issues, but lack diagnostic tools and application guidelines to employ behavioral finance research with clients. to it. Furthermore, quantitative guidelines need to be available when modifying asset allocations to account for biased behavior. Practitioners should adapt to biases at high wealth levels and attempt to modify behavior at lower wealth levels.They should adapt to emotional biases and moderate cognitive biases. These actions will lead to a client's best practical allocation. Three case studies illustrate how these guidelines are applied. A quantitative model is also unveiled that calculates acceptable discretionary distances from the mean-variance output for determining the best practical allocation. The article offers practitioners a framework to better understand how behavioral finance can be applied to their individual clients.

Michael M. Pompian, CFA, CFP"', is a wealth management advisor at a global financial services firm and is based in northern New Jersey. He advises private clients in portfolio construction, financial planning, and wealth transfer strategies. Mr. Pompian can be reached at (888) 807-1753 or mpompion@hotmail.com.

John M. Longo, Ph.D., CFA, is chairman of the Investment Committee at The MDE Group, an investment advisory firm. He is also a faculty member in the Finance and Economics Department at the Rutgers Business School. Dr. Longo can be reached at drfinance@comcast.net or {609} 730-8281.

Mr. Pompian and Dr. Longo have published several articles on the subjea of practical application of behavioral finance.

Many clients would be well served by adjusting their asset allocations to account for biased behavior. By doing so, they would stand a better chance of adhering to their investment programs and enjoy better long-term investment results. • In applying behavioral finance research to client situations, practitioners must decide whether to attempt to change their clients' biased behavior or adapt

or many experienced wealth management practitioners, the task of creating and delivering investment solutions to private clients cultivates both a keen awareness of "less than rational" decision-making and a potential interest in the branch of economics—bchin ioral finance— that provides insights into irrational investor behavior. AVhy. then, has the rohust body of behavioral finance research not enjoyed mainstream application? Practitioners employ but a few ofthe significant number of investors' behavioral "biases"—defined as systematic errors in judgment—that have been identified by researehers. Why nor more, and u hv have
Journal of Financial Planning/March 200S

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practitioners failed to consider behavioral biases in the critici! duty of designing asset allocation programs for their clients.^ The authors offer two primary explanations for this phenomenon, and contend that once these issues are resohed, behavioral finance will represent a new and \ ast frontier in seiTing clients. First, behavioral biases, as presently articulated, are not user-friendly because there is not a w idely accepted "industry standard" methodology of identifv ing an individual investor's biases. Researchers have done a significant amount of work to reveal behavioral biases, which are cer-

tainlj- usable, l)ut practitioners would enormously benefit from a comprehensive volume, w hich does not prcsentl}' exist. Second, if an investor's behavioral biases luivc been identified, practitioners lack the guidelines necessar}' for incorporating these biases during the process of determining asset allocation. Developing pR)per guidelines for incorporating biases in as.set allocation decisions—the focus <)f this paper—-requires answering central ([uestions: 1. When should advisors attempt to moderafethe way clients naturally behave to counteract the effects of behavioral
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because emotional biases originate from impulsive feelings or intuition— rather than conscious reasoning—they are difficult to correct. we will call this . Jones. in the latter. the client's standard of living may be jeopardized.9'' percentile.1 client. When should advisors create asset allocations that .) 2.net Guidelines for Determining Best Practical Allocation The authors offer two propositions for guiding practitioners in identifying the best practical allocation for their clients while considering behavioral biases: Proposition I.uiapt ro clients' biases. who are susceptible to behavioral biases. what quantitative parameters should be in place when putting the moderate or adapt recommendation into action? These i|uestions u ill be explored. yield a blended recommendation. the client's standard ot living will remain in the 99. such as a market crash for those clients w ith market-based wealth. For instance. hindsight. the more the practitioner should adapt to the client's behavioral biases. such as anchoring and adjustment. that his or her asset allocation be changed. Mr. in response to short-term market movements and to the detriment ofthe long-term investment plan. But if only an unlikely event. loss aversion. so that clients can comfortably abide by their asset allocation decisions? (For purposes of this paper. a less wealthy client w ith strong emotional biases should be both adapted to and moderated. Behavioral biases fall itito two broad categories—cognitive and emotional—though both types yield irrational decisions. Smith. the wealthier the client. Best Practical Allocation Practitioners are often vexed by their clients' decision-making process when it comes to allocating their investment portfolio. A client's outliving his or her assets constitutes a far graver investment failure than a client's inability to amass the greatest possible fortune. Ihe less wealthy. In designing a standard asset allocation program with a client. a client's best practical allocation may be a slightly under-performing long-term investment program to which the client can comfortably adhere. In the former case. Although this process may work well for institutional investors." Serving the best interest of the client may be the recommendation of an asset allocation that suits the client's natural psychological preferences-—and may not be one that maximizes expected return for a given level of risk. Specifically. for some clients. practitioners may more easily and fruitfully :ipply the body of behavioral finance research. availability. The decision w hether to moderate or adapt to a client's behavioral biases during the asset allocation process depends fundamentally on the client's level of wealth. 'I he cases of three hypothetical investors—\ts. Propositions I and II can. who have made significant contributions to www. then discuss the client's financial goals and constraints. More simplv.Pompian Contributions biases so that they can "fit" a pre-determined asset allocation? (For purposes of this paper. Conversely. Specifically. Let's explore why this may happen. clients may exhibit the same biases.u/. Because cognitive biases stem from faulty reasoning. Rationale. another client's best practical allocation may be one that goes against his or her natural psychological tendencies. 'I hus equipped. Additionally. Figure 1 illustrates this concept. and guidelines will be delineated for taking investor biases into account to create w hat the authors have termed the best practical alk)cation for a client. "Fhe decision u hether 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. a client demands. and representativeness biases. if bias is likely to endanger a client's standard of living. w hiie those exhibiting emotional biases should be adapted to. could jeopardize the client's standard of living. Once the decision is made to either moderate or adapt. Rationale. Kmotional biases include regret.J/)f/ii^ to . lack of self-control. In a common scenario. and then typically recommend the output of a mean-varianee optimization.journalfp. (Conversely. (3ther cognitive biases include selective memory and overconfidence. it often fails for individuals. These biases will be described in more detail in the next section of the paper. Proposition II. we will call this moderating a client. In otlier words. moderating is the hest course of action. but should he advised differently. w hile illustrating how praetitioners can apply these propositions to determine Itest practical allocation. bias liecomes a lesser consideration. describe financial advising as "a prescriptive activity whose main objective should be to guide investors to make decisions that serve their best interest. and the client may be w ell-served to accept more risk than he or she might otherwise be comfortable with—to maximize return for a given level of risk. and denial. practitioners first administer a risk tolerance questionnaire. better information and advice can often correct them. Journal of Financial Planning/March 2005 .) }. clients exhibiting cognitive biases should be moderated. and adapting may be the more appropriate action. Cognitive biases include heuristics. behavioral finance. the more the practitioner should moderate a client's biases. and the Adams family—w ill add clarity to these complexities. Nobel prize-winner Daniel Kahneman and co-author Mark Riepe (1998).

15 percent stocks.yale. What effect do a client's biases have on the asset allocation decision? 2.edu Richard Thaler— www. want tt) lose money because she recalls that her relatives lost mone). not expected to grow significanth'.asp Meir Statman—www. He lives extravagantly. both aged 36. Smith's biases are very consistent and lead to a clear allocation preference. 5 percent cash • I lie Adams famiK': 70 percent stocks.000. The Adams suffer from: • Loss aversion • Regret—the tendency to feel deep disappointment for having made incorrect decisions • Availability bias—the tcndenc\' to believe that \\ hat is easily recalled is more likeK' Further assume that it is 2001: capital markets are off their highs (for stocks) and lows (for bonds). I he Adams family includes a financially v\ ell-informed couple. Effea of biases. administer a risk tolerance i|uestionnaire. Smith 1.. Because Ms. After you.edu/ Daniel Kahneman— www.psychologyand market5.uchicago. . but not yet at the extremes ofthe recent market cycle.5cu. under any circumstances. Smith does not tolerate risk (loss aversion) and www. Smith is a single 65-ye.com Journal of Psychology and /Wcjr/cefs—www. Ms.iijournals.com/JPPM/ default.investment goal is to donate $.com Journal of Wealth t^anagement— www.Ms. $ 120.Contributions Pompian High Level of Weaith (Adapt) Moderate and ••••• Adapt 1 1 Emotional Biases (Adapt) Cognitive Biases (Moderate) I ^ Moderate Moderate I and I Adapt 1 r Low Levei of Wealth (Moderate) Case Studies Case A.? million to his alma mater. but he cannot obtain life insurance.Joumalfp.inve5torpsych. occasionally spending more than his income.lsb. Jones: H5 percent stocks.net Journal of Financial Planning/March 2005 . I'hev have saved $150. but were not invested during the hull market ofthe 19y()s as many of their neighbors were. Her jirinian' invest- Helpful Web Sites Investor Personality Type Testing—www.designed to help practitioners ansv\ er three fundamental questions: 1.gsb. but has saved approximately $!. pri nceton .ir-i)kl v\ith a modest lifest\'Ic and no income beyond \\ hat her investment portfolio of $1 million generates.edu Robert Schiller— www.'' million.in the crash of 1929. Jones exhibits the following biases: ' Loss aversion • Overconfidence—the tendency to overestimate one's investment savvy • Lack of self-control—the tendency to spend today rather than save for tomorrow Case C. like the family itself. What is the best practical allocation for each investor? Solution to Case A: Ms. is. His primar).edu Undiscovered Managers listing of behavioral finance researchers— www. the practitioner. Should \ou moderate or adapt to these biases? ?. the mean-variance optimizer yields the follow ing allocations for each ofthe three investors: • Ms. 10 percent bonds. com/Behavioralpercent20 Finance2. undiscovered managers. 10 pcTccnt cash • Mr. and two children aged 4 and 6. Jones is a single 50-\ear-old pharmaceutical executive earning $250. 5 percent cash 1 hese case studies w ert. Mr. Mr.000 a year.econ. which they hope will be the financial f{)undation from v\ hich they u ill send their children to college and retire comfortably. The couple's total income. They are financially sound. Ms. Smith e.\hihits these hchavioral hiases: • Loss aversion—the tendency to feel the pain of losses more than the pleasure of y:ain • Anchoring and ailjustment—the tendency to believe that current market levels are "right" by unevenly weighting recent experience • Selective memory—the tendency to reeall only events consistent with one's understanding ofthe past Case B.htm ment goal is to not outlive her assets: she does not. 25 |>ercent bonds.000. Smith: 75 percent bonds.

because he does not tolerate losses (loss aversion) and has a FP 1. Additionally.Ms. CA meeting i^or finffloffl^H^^^H^cv&vone involved in" attendance at FPA San Diego 2005 as a ''must do" to ensure pi San Diego provides the serene backdrop for the 2CK)5 convened of pristine beaches and dazzling array of world-class family d thiiii^s to see and do. Best practical allocation decision. Jones's biases do not provide a clear indication of what allocation he would naturally prefer. presented her with an allocation of 100 percent bonds. the best practical allocation is the precise allocation that the mean-variance optimix-er provided. if you. Moderate or adapt? Given . . 75 percent bonds. she would be likely to immediately agree with that recommendation.\lr. You recommend this allocation to Ms. his overconfidcnce may lead him to be more comfortable with equities than is appropriate for him. as her advisor. FPA San jng commu "ssional longevity. and these types of biases can In.net journal of Financial Planning / March 2005 . 2.Pom pi an Contributions recalls that her relatives lost money (selective memory). /\. f his being the case. Smith's !ii.issrmbiv ol tlu' ilnancial planning communi"" . 70 milr in Diego offers a wide varit't\ ot 'X miss the opportunity to attend Ihe •n Diego 2005! Visit wwvv. you need to consider her liias toward such an allocation.s we have decided to moderate Ms.FPAAnnualConvrntinn. your tlnancial planning software tells vou that Ms. 10 percent cash. and administer a continuing program of investor education on the risk of outliving one's assets. Smith. Effect of biases. a clearly unacceptable outcome. and adjustment).r San Diego Convention Center September 15-18. 3. her biases are principally cognitive (selective memory. appealing to guests trom around the wo" world's fori'mo^t .jDumalfp.more aggressive allocation the optimizer recommended. she will likel\' make faulty conciu. she would naturally prefer . she will be wary of any exposure to equities.ises. stiear-idvllic climate.since the market has dropped recentl) . 15 percent stocks. On the other hand. On the one hand.i safe and secure allocation. the correct course of action is to moderate her bias preferences and recommend that she accept some risk in her [njrtfolio. 2005 San Diego.sions about current market prices (anchoring antl adjustment). Thus.Additionally.org for developing programming news. Smith's lc\L-! nf wealth. and recommend an allr>cation to I(K) percent Ixmds. Jones 1. if you adapt to her biases. . Solution to Case B: Mr. corrected \\ ith advice and information that w ill help her understand that she would be at risk if she accepted a 100 percent hond portfolio. Your recommendation is to help her overcome her behavioral biases and advise her to "fit" the slightl}. anchoring. However. Smith runs the risk of outliving her assets. San Diego travel tips and registration material See you in San Diego! vvww. .

2.5 million versus his original goal of $3 million. "How Much to Moderate or Adapt. H) percent bonds. Moderate or adapt? The Adams family's biases are mainly emotional (loss aversion. Mr. regret). In this case. [ones clearK' does Journal of Financial Planning/March 2005 not run a standard-of-Hving risk. and be able to adhere to. lack of self-eontrol). Because the Adams family's portfolio has not kept pace \\ ith tht'ir neighbors'. 15 percent bonds. your financial planning software suggests that a lower equity allocation w ould not provide a secure retirement given their college expenses: that is. but further analysis is rei|uired. But because they d(j not tolerate risk (loss aversion) and have shrunk from the latest information about the . wwwjournalfpjiet . We are once again presented \\ ith biases that lead us in different directions. The mcan-varunicc optimizer's recommended allocation was 85 percent stocks. such an allocation. you decide that indeed the appropriate recommendation is to adapt to his biases and create a less aggressive portfolio to 1. they are more comfortable with less exposure to equities. w hich may prompt them to take on more equity risk than may be appropriate." your judgment is that an allocation of 75 percent stocks. 10 12% I -5 100% \ Bias Adjustment Factor = Change In Absolute Value Percent Change In Weighted Average Percent Bias Adjustment Factor = high need for current income that supplements his "spend today" mentality (lack of self-control).s alma mater may receive $2. Jones that hi. he sees the benefit affixed ineome investments. Given these two facts. Effect of biases. 10 percent cash is appropriate. . Best practical allocation decision.Contributions Pompian Low Level of Wealth (Moderate) which he w ill be able to adhere and be comfortable with. But given their level of \\ caltli.Again in this case. Solution to Case CThe Adams Family Distance from Mean-Variance Output for Mr. Thus. 2. your instinct is to adapt to a lower allocation to equities of 50 percent V)ecause you believe that the Adamses are likeK to be comfortable u ith. You also caution Mr. Additionally. and given that he naturally prefers an allocation favoring fixed income. his behavioral biases are principally emotional (loss aversion. biases favoring fixed income outu eigh those favoring equities. biases favoring fixed income appear to outweigh those favoring equities—we need to thoughtfully consider the situation further. Jones Mean Variance Output Fixed Income Equities Cash 10 85 5 too Bias Adjusted Allocation 15 75 10 100 Change in Absolute Value Percent I ' : Change in Weighted Average Percent 5% 10% 5% Difference -5 50% . Using guidelines presented a later section of this paper. 5 percent eash. the Adamses regret having made incorrect decisions in the past.skidding equity market (availabilirvO. 3. Moderate or adapt? When considering level of wealth.

For example. 3. lier bias adjustment factor is 0 percent.5 and allow our reprint coordinator to assist you with some proven marketing ideas. 25 percent bonds.s ranges of plus or minus 10 percent in either direction.^5 percent bonds. Montier.s. 2002. You had contemplated dropping the equity allocation to 50 percent ba. Subtract each bias-adjusted alloeation from the mean-variance output. Jones and the Adams Family. Take the absolute value. 1998.net Endnote 1. Jtieprints Customize 73 your How Much to Moderate or Adapt The decision to override the mean-variance i)[)timizer will cause a deviation from the National" portfolio. Figure 2 supplements 1-igure 1 by providing a visual description of these three cases. The authors offer a method of calculating acceptable discretionary "distances" from the mean-variance output. Tables I and 2 show the calculations that justified the best practical allocations for Mr. The nican-variarice optimizer's recommended allocation was 70 percent stocks.\hirkets. striking a balance between their investment goal. You decide to compromise. Riepe. www. 2000. [practitioners normally have the discretion ro have equities range from 50 [lercent to 70 percent. Fall: 9-15. Method for Determining Appropriate Deviations from the Rational Portfolio 1.Pompian Contributions their standard of living is at stake. Summer: 52-f>4. it is recommended that allocations not stray more than 20 percent from the mean-variance optimizer without extensive client consultation. Bvvond (irccd and Fear: Understanding Hchinionii limincc and the Psychology of Investing. D. These case studies have demonstrated the process by which we can arrive at the best practical allocation u hile eonsidering l)ehavi{)ral biases.s and biases. H. REPRINTS EPRINTS PLAQUES POSTERS . Longo. You recommend this allocation to the Adams family. 5 percent cash. Sum lo determine bias adjustment factor.it Investor Journal of W'cAhh Management.sed on their bia. England: yo/j/i Wiley & Sons Ltd. M. and M. 2003.joumalfp. "Aspects of Investor Rsychology.se of 60 percent stocks. . and the result will be that practitioners will better serve clients' best interests. and J. Uchnvinnnil Finnncc: Insights inco Irnniomil Mimls unJ . 3. The Art of Asset Allocation. Smith's bias-adjusted allocation did not differ from the mean-variance output. nal of Portfolio Ahinngemcnt. j . and your recommendation is to moderate and adapt. The authors undoubtedly believe that the future of advising private clients will include behavioral fmance research. Kahneman." Forthcoming in Institiition. Conclusion The propositions and cases presented here provide guidelines for practitioners to incorporate behavioral finance into asset allocation design to create what the authors have termed the best practical allocation for a client. New York: McCIraw-Hill." /rx/ . if a "sample" balanced portfolio is defined as 60 percent equities/40 percent fixed income.ses. 2004. "A New Paradigm for Practical Application of Behavioral Finance: Creating Investment Programs Itaseti on Personality Type and Gender to Produce Better Investment Outcomes. Journalof Financial Planning/March 2005 References Darst. For purposes ofthis paper assume that Mr. Divide each mean-variance output by the difference. and Mrs. and fixed income mighi range from 30 percent to 50 percent. Best practical allocation decision. West Sussex. I). Thus you bring the equity allocation up to 60 percent. Shefrin. which results in a compronii. Adams have a common set of behavioral biases. Ms. Boston. The justification for the 20 percent range is that most investment [tolicy statements permit discretionary asset cla. but realized that sucb an allocation would present a standard-ofliving risk. Weight each percentage change by the mean-variance output base. Pompian. 5 percent cash allocation. 2. MA: Harvard Business Sch))ol Press.