Behavioral Asset Allocation Revised Victoria 100921

Psychological influences on investor decisions
A behavioral finance approach to

strategic asset allocation
The CFA Society of Victoria
Victoria, BC
September 21st, 2010
Jean L.P. Brunel, C.F.A
Three main points …
The inadequacy of current approaches:

A different model:
A practical application:
The inadequacy of current tools …
Current x
2,000,000,000 Index Values (USD)
x x
Compound Growth of Assets
approaches
x
1,000,000,000
906,591,154
involve heavy E[r]

836,568,109
645,925,289
quantitative 515,550,842
input based on  400,000,000

Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec
1995 1995 1996 1996 1997 1997 1998 1998 1999 1999 2000 2000 2001 2001 2002 2002
Time
Sep
2003
highly
Returns Histogram
Returns Histogram
qualitative
Rolling Style Distribution
Area Graph for Arden In stitutional Advisors - Estim ated Weights
Number Weights
28 100.0%
data … We do 26 90.0%
80.0%
24 70.0%
22 60.0%
not speak the

20 50.0%
18 40.0%
30.0%
16
20.0%
14
same
10.0%
12 0.0%
10 Oct Dec Dec Dec Dec Dec Dec Dec Sep
8 1995 1996 1997 1998 1999 2000 2001 2002 2003
language … 6 Time
HFRI Convertible Arbitrage TR HFRI Distressed Securities TR
4 HFRI Emerging Markets TR HFRI Equity Hedge TR
2 HFRI Equity Market Neutral TR HFRI Event-Driven TR
0 HFRI Fixed Income Arbitrage TR HFRI Macro TR
-4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% HFRI Merger Arbitrage TR HFRI Rela tive Value Arbitrage TR
Return HFRI Short Selling TR HFRI Statistical Arbitrage TR
What is the problem?
The process is Highly quantitative results, based on rough

driven by an answers
apparent
desire to fit No focus on the way the individual views the
each investor problem
into the same
set mold … Jargon overload
What is missing?
A healthy and meaningful interaction

A solution based on:
o What “I,” the investor, want … and
o How “I” want it
In short, a solution:
o With which I can associate
o and with which I can live over time
An alternative model
Imagine a Describing investors goals:

completely o think of a menu of dishes, …
different o not of a menu of ingredients
approach, one
starting with Prioritizing and dollar weighting them:
the investor…
Constructing appropriate sub-portfolios:
o To “defease” each goal
o in a way that makes sense to the investor
Combining them in an overall portfolio:
Behavioral finance insights …
Behavioral
finance starts
where
standard
finance fails
to explain or
predict
individual
behaviors or
needs …
Three fundamental goals…
HNW Personal:
investors o Meet current and unanticipated needs
usually have o Maintain future flexibility
three distinct
generic goals Dynastic:
that competes o How much should my children get?
for their o What about generations beyond them?
attention …
Philanthropic:
o Active or passive philanthropy
o Philanthropy as a family value
The behavioral finance portfolio …
This design, Investment risk

initially
proposed by Dynastic
Dynastic
Aggressive Strategies
Meir Statman,
Passive
illustrates the Philanthropic Philanthropy Balanced Growth Portfolio
fact that we
have different Flexibility Changes in dynastic/life- Balanced Portfolio
style and active philanthropy
views of risk
for different Personal Tax-efficient, conservative
Lifestyle Portfolio. Risk taken
goals … Only to preserve long-
Shelter and food term purchasing power
Behavioral Disutility of losses vs. utility of gains:

finance theory o Downside risk minimization
helps us
understand
how investors
behave rather
than tell how
they should
behave…
Behavioral Disutility of losses vs. utility of gains

helps us
understand Limited framing and hindsight biases:
how investors o Reactive decision mode
behave rather
than tell how
they should
behave…

helps us
understand Limited framing and hindsight biases
behave rather
than tell how Overconfidence and illusion of control:
they should o Momentum style
behave…

helps us
behave rather
than tell how Overconfidence and illusion of control
behave… Regrets:
o Changing horses in mid race

helps us
behave rather
than tell how Overconfidence and illusion of control
behave… Regrets
o Changing horses in mid race
Asset class or strategy prejudice
Goal-based asset allocation …
How do you Identify goals with which we can associate:

pick you meal o Liquidity
in a o Income
restaurant? o Capital preservation
From a menu o Growth
of dishes or a
menu of
ingredients?
Identify goals with which we can associate

o Liquidity
o Income
o Capital preservation
o Growth
Structure sub-portfolios for each goal:
o Manage
o Report
Identify goals with which we can associate

o Liquidity
o Income
o Capital preservation
o Growth
Structure sub-portfolios for each goal
o Manage
o Report
Consider the full picture as a fiduciary
Four goals and more…
We need to Operating businesses

remain
Opportunistic investments or trades
flexible in
designing Collectibles
these goals,
Others
as an
investor
might prefer
others …
The process, in short …
Describe the Dollar weigh and

main goals of prioritize these
our investor goals
Optimize these Structure a sub-

portfolios across portfolio for
the whole each goal
An illustrative case study …
John and Debbie, early 50’s, 4 children

$1 million AT spending needs
Want to start generational transfers
$5 million minimal philanthropic goal
$50 million in assets, yet …
… fear not having enough …
Their current
Current Portfolio Allocation
portfolio is
Cash & Related
poorly
constructed Fixed Income
9.9% 9.8% 19.9%
with little 2.7% Non-Directional Multi-
alternative Strategy
Traditional Equities
asset exposure
and much too 4.8%
10.4%
Private Equity
much cash… Semi-Directional Multi-

42.5%
Strategy
Real Assets
Current expected AT return: 7.4%
Current expected AT volatility: 8.1%
The first step Liquidity: $1 million

is to create the o AT spending needs for a year
appropriate
“bucket”
exposures.
Liquidity: $1 million
o AT spending needs
Income: $8.2 million
o To defease $1 mil/year for 10 year, 2% CPI
o Assumes a 5.5% after tax return
o AT spending needs
Capital preservation: $5.4 million
o To defease spending needs for years 11-20
o Assumes a 6.1% after tax return
o AT spending needs
Real assets: $4.9 million
o AT spending needs
Real assets: $4.9 million
Growth: $30.6 million
Note the size The growth portfolio allows:

of the o Compounding for the future
“growth” sub- o Early philanthropic giving
portfolio… o Early generational transfers
Note the size The growth portfolio allows

of the o Compounding for the future
“growth” sub- o Early philanthropic giving
portfolio… o Early generational transfers
and the
allocation can Income and capital preservation can be
be viewed in o Allowed to “mature”
dynamic o Topped up and rebalanced annually
terms …
Back to the case study …
o AT spending needs
Growth: $30.6 million + $4.9 in real assets
Note that each Optimized Bucket Allocation

sub-portfolio
makes sense,
Liquidity Income
relative to its
Fixed Income
own basic 25.0%
goal … Cash &

Related
75.0% Non-Directional
100.0% Multi-Strategy
Capital Preservation Growth

Semi-
10.0% 5.0% 10.0% Directional 12.5% Traditional
Multi-Strategy 37.5% Equities
30.0% Real Assets 40.0%

45.0% Private Equity
10.0%
The newly Optimized Portfolio Allocation

allocated Cash & Related
portfolio
Fixed Income
satisfies their 10.2% 2.8%
16.0%
individual 24.5% Non-Directional Multi-
14.4%
goals more Strategy
Traditional Equities
closely, and
seems much Private Equity
more efficient 6.4%
25.6% Semi-Directional Multi-
in financial Strategy
terms … Expected AT return: 8.3% (+0.9%) Real Assets
Expected AT volatility: 7.3% (-0.8%)
Different rebalancing risks …
Set once and allowed to mature…

o Until needs change …
o Or until cash has run out!
o Risk = worries as horizon-end approaches
Reviewed each year
o Various buckets are rebalanced
o Until no need to keep thinking that way …
o Risk = over-exposure to low risk assets
Combining all in one …
This overall Each bucket

portfolio o Reinforces validity of choice
seems to
make sense, Aggregate
particularly o Meets goals in an understandable manner
when one Capital Overall
Liquidity Income Preservation Growth Portfolio
looks at return Expected P T Compound Return 6.08% 8.32% 8.84% 10.98% 10.26%
and risk Expected A T Compound Return
Expected Risk (Pretax)
3.95%
4.06%
5.45%
5.27%
6.02%
4.10%
9.04%
11.53%
7.98%
8.15%
expectations Expected Risk (After-Tax) 2.64% 3.44% 2.77% 10.25% 7.05%
Return per Unit of Risk (Pretax) 1.50 1.58 2.16 0.95 1.26
per sub- Return per Unit of Risk (After-Tax) 1.50 1.58 2.17 0.88 1.13
Sharpe Ratio (Pretax) 0.49 0.80 1.16 0.60 0.76
portfolio … Probability of Negative 12 Mos 6.73% 5.74% 1.55% 17.06% 10.40%
Probability of Negative 36 Mos 0.48% 0.32% 0.01% 4.96% 1.46%
Introducing asset location …
Note the Optimized Asset Location

scope for
asset location
flexibility and Taxable Tax-Exempt Cash & Related
that the tax- Fixed Income
exempt pocket 0.6% 3.5% Non-Directional

11.7%
comprises tax- 27.0% 19.1% 25.3% Multi-Strategy
Traditional
inefficient Equities
Private Equity
strategies … 6.9% 27.1% 15.9% 63.0%
Semi-Directional
Multi-Strategy
Real Assets
Three unintended benefits …
More sensible tactical rebalancing

o Each move makes sense within sub-portfolio
o Bet size consistent with goal breakdown
Promotes better advisor-client dialog
o Income needs in relation to assets
o Funding of very large asset purchases
Well suited to the use of FLP’s:
o FLP focused on goal, not asset class
o Allocation variations across generations
The current environment …
Dealing unusual conditions

o Managing decision risk is real
o What if capital market theory had holes?
Varying the definition of buckets
o Goals versus fears
o Intermediate versus long term
Same issue: “relating to one’s portfolio”
o Understanding the language
o Dealing with unusual/abnormal events
In short …
Current approaches have tight limits

The issue is all about making sense
Making sense reduces stress
Less stress reduces decision risk
Coping in difficult times
o Fundamentally required
o Emotionally necessary
Psychological influences on investor decisions
A behavioral finance approach to

strategic asset allocation
The CFA Society of Victoria
Victoria, BC
September 21st, 2010
Jean L.P. Brunel, C.F.A

Behavioral Asset Allocation Revised Victoria 100921

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Behavioral Asset Allocation Revised Victoria 100921

Uploaded by

Copyright:

Available Formats

Psychological influences on investor decisions

A behavioral finance approach to

The inadequacy of current approaches:

involve heavy E[r]

input based on  400,000,000

not speak the

The process is Highly quantitative results, based on rough

A healthy and meaningful interaction

Imagine a Describing investors goals:

This design, Investment risk

Behavioral Disutility of losses vs. utility of gains:

Behavioral Disutility of losses vs. utility of gains

Behavioral Disutility of losses vs. utility of gains

Behavioral Disutility of losses vs. utility of gains

Behavioral Disutility of losses vs. utility of gains

How do you Identify goals with which we can associate:

Identify goals with which we can associate

Identify goals with which we can associate

We need to Operating businesses

Describe the Dollar weigh and

Optimize these Structure a sub-

John and Debbie, early 50’s, 4 children

much cash… Semi-Directional Multi-

The first step Liquidity: $1 million

Note the size The growth portfolio allows:

Note the size The growth portfolio allows

Note that each Optimized Bucket Allocation

goal … Cash &

Capital Preservation Growth

30.0% Real Assets 40.0%

The newly Optimized Portfolio Allocation

Set once and allowed to mature…

This overall Each bucket

Note the Optimized Asset Location

that the tax- Fixed Income

exempt pocket 0.6% 3.5% Non-Directional

More sensible tactical rebalancing

Dealing unusual conditions

Current approaches have tight limits

A behavioral finance approach to

You might also like