CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r18 asset allocation with real world constraints IFT notes

This reading also discusses making short-term shifts in asset allocation and the impact of an investor’s behavioural biases on his investment portfolio.. Some of the most important const

Asset Allocation with Real World Constraints

1 Introduction 2

2 Constraints in Asset Allocation 2

2.1 Asset Size 3

2.2 Liquidity 5

2.3 Time Horizon 5

2.4 Regulatory and Other External Constraints 7

2.4.1 Insurance Companies 7

2.4.2 Pension Funds 8

2.4.3 Endowments and Foundations 8

2.4.4 Sovereign Wealth Funds 8

3 Asset Allocation for the Taxable Investor 9

3.1 After-Tax Portfolio Optimization 9

3.2 Taxes and Portfolio Rebalancing 12

3.3 Strategies to Reduce Tax Impact 12

4 Revising the Strategic Asset Allocation 13

5 Short-term Shifts in Asset Allocation 14

5.1 Discretionary TAA Error! Bookmark not defined 5.2 Systematic TAA Error! Bookmark not defined 6 Dealing With Behavioral Biases In Asset Allocation 15

6.1 Loss Aversion 15

6.2 Illusion of Control 16

6.3 Mental Accounting 16

6.4 Representative Bias 16

6.5 Framing Bias 17

6.6 Availability Bias 17

Summary from the Curriculum 18

Examples from the Curriculum 21

Example 1 Asset Size Constraints in Asset Allocation 21

Example 2 Liquidity Constraints in Asset Allocation 23

Example 3 Time Horizon Constraints in Asset Allocation 24

Example 4 External Constraints and Asset Allocation 24

Example 5 Asset Allocation and the Taxable Investor 26

Example 6 Revising the Strategic Asset Allocation 28

Example 7 Short-Term Shifts in Asset Allocation 30

Example 8 Mitigating Behavioral Biases in Asset Allocation 32

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1 Introduction

This reading is a part of a sequence of three readings that will cover asset allocation The reading talks about the real-world challenges in developing an asset allocation and addresses the ways in which the asset allocation can be accommodated to asset owner’s circumstances and constraints (including asset size, liquidity, time horizon, tax status, etc) This reading also discusses making short-term shifts in asset allocation and the impact of an investor’s behavioural biases on his investment portfolio

This section addresses LO.a:

LO.a: discuss asset size, liquidity needs, time horizon, and regulatory or other considerations as constraints on asset allocation;

2 CONSTRAINTS IN ASSET ALLOCATION

The asset allocation choice of an asset owner must incorporate the asset owner’s constraints Some of the most important constraints that may influence the investment opportunity set or the optimal asset allocation decision include the following:

The size of an asset owner’s portfolio may limit the investment opportunity set

Too large portfolio size:

Pros of large portfolio size: Asset owners with larger portfolios can

 build a diversified portfolio of a broader set of asset classes and investment strategies

 invest in more complex asset classes and investment vehicles as they may have sufficient

governance capacity and staff resources to evaluate such asset classes

 better negotiate fees with external managers

 have larger allocations to private equity and real estate investments

Cons of large portfolio size:

 It is difficult for too large portfolios to efficiently capture the returns of asset classes with low

market capitalization and certain active strategies

 Large size portfolios tend to have large trades and thus, can lead to high price impact

 Large size portfolios tend to have liquidity issues

 Large size portfolios may have an overexposure to some fund managers

 In larger size portfolios, fund managers may have to make investments outside their area of

expertise

 In larger size portfolio, the decision-making process is slowed down owing to organizational

hierarchies

Too small portfolio size:

 The portfolio might be too small to efficiently capture the returns of certain asset classes and

strategies such as hedge funds, private equity, and real estate

 Smaller size portfolios do not have economies of scale

 Smaller size portfolios may not have enough resources for sophisticated governance

 Smaller size portfolios tend to have high management fee relative to AUM

 Asset owners of smaller size portfolios have low negotiation leverage

 The portfolio might be too small to effectively diversify across asset classes

 The portfolio might be too small to meet minimum investment requirements

 Asset owners of smaller size portfolios cannot invest in complex strategies due to lack of investment expertise / knowledge

Curriculum Example: The following example illustrates some of the issues associated with managing a

large asset pool

Consider an asset owner with an investment portfolio of US$25 billion who is seeking to make a 5% investment in global small-cap stocks The median total market capitalization of the stocks in the S&P Global SmallCap is approximately US$555 million

Assume a small-cap manager operates a 50-stock portfolio and is willing to own 3% of the market cap of any one of its portfolio companies

 Their average position size would be US$17 million ($555 X 3%);

 An effective level of assets under management (AUM) would be on the order of US$850 million ($17

X 50 stocks)

Issue: Beyond that level, the manager may be forced to expand the portfolio beyond 50 stocks or to

hold position sizes greater than 3% of a company’s market cap, which could then create liquidity issues for the manager

Now, our US$25 billion fund is looking to allocate US$1.25 billion to small-cap stocks (US$25 billion × 5%) They want to diversify this allocation across three or four active managers

 The average allocation per manager is approximately US$300 to US$400 million, which would constitute between 35% and 50% of each manager’s AUM

Issue: This exposes both the asset owner and the investment manager to an undesirable level of

Asset Class Investor Constraints by Size

Cash and money market funds No size constraints

Large-cap developed market equity

Small-cap developed market equity

Emerging market equity

Generally accessible to large and small asset owners, although the very large asset owner may be constrained in the amount of assets allocated to certain active strategies and managers

Developed market sovereign bonds

Investment-grade bonds

Non-investment-grade bonds

Private real estate equity

Generally accessible to large and small asset owners, although to achieve prudent diversification, smaller asset owners may need to implement via a commingled vehicle

• Timberland and farmland

May be accessible to large and small asset owners, although if offered as private investment vehicles, there may be legal minimum qualifications that exclude smaller asset owners The ability to successfully invest in these asset classes may also be limited by the asset owner’s level of investment understanding/expertise Prudent diversification may require that smaller asset owners implement via

a commingled vehicle, such as a fund of funds, or an ancillary access channel, such as a liquid alternatives vehicle or an alternatives ETF For very large funds, the allocation may be constrained by the number of funds available

Refer to Example 1 from the curriculum

2.2 Liquidity

There are following two dimensions of liquidity which have implications on asset allocation decision:

i The liquidity needs of the asset owner;

ii The liquidity characteristics of the asset classes in the opportunity set

 In general, longer time horizon implies low liquidity needs and thus, the portfolio can be invested in less-liquid asset classes

 We should also consider liquidity needs under high market stress For example, if there is a large

endowment fund, which is required to pay for the operating expenses of a university In this case,

we need to consider what happens to the university if there is a major stress in the market, say an economic downturn, and as a result, the endowment is required to make higher contributions to the university Due to higher liquidity needs, the endowment needs to invest in highly liquid assets

 Governance capacity also has implications on liquidity needs If governance capacity is strong, then this would result in greater ability to invest in less liquid asset classes

 For developing appropriate asset allocation, we should also consider the particular circumstances of

an asset owner, the asset owner’s financial strength and the asset owner’s resources beyond the investment portfolio

Examples:

 An investment portfolio of a bank which is used to support its day-to- day operations tends to have

a very high turnover and a very high need for liquidity; therefore, this portfolio must be invested in high-quality, very short-term, and highly liquid assets

 On the other hand, some portion of a long-term investment portfolio of a bank may be invested in less liquid investments to seek higher returns

 Unlike property/casualty reinsurers (whose losses are subject to unpredictable events), life

insurance company or auto insurance companies can assume more liquidity risk as their losses are actuarially predictable

 The liquidity requirement of a family with several children nearing college-age will be greater than that of a couple of the same age and circumstances with no children

Refer to Example 2 from the curriculum

2.3 Time Horizon

An asset owner’s time horizon is a critical constraint that must be considered while developing asset allocation because as time passes, the nature and composition of the asset owner’s assets (i.e human capital) and liabilities tend to change There are two major time horizon related constraints

a) Changes in human capital: As investor ages, the human capital, which is considered to be bond-like

in nature in terms of risk, decreases, and as a result, the percentage of bonds in total asset

allocation increases

b) Changing character of liabilities: In case of a pension fund, if employee base is young and

retirements are far into the future, the structure of the liabilities can be characterized as long-term bonds In contrast, when employee base ages and retirements are not so far into the future, the structure of the liabilities can be characterized as intermediate or short-term bonds When

retirements are in very near future, the liabilities can be hedged using cash-like securities

Time horizon also affects the priority of meeting certain goals and liabilities, which in turn influence the desired risk profile of the assets used to fund them

Curriculum Example: Consider a 75-year-old retired investor with following two goals:

1) Fund consumption needs through age 95, assuming a lower probability of living beyond age 95 and sufficient assets to fund this goal This goal would be assigned a higher priority, which implies, the investor would take less risk and thus, this sub-portfolio will be invested more conservatively 2) Fund consumption needs from age 95 through age 105, assuming the funds available would be able

to partially fund this goal Given the low probability of living past 95 and not sufficient assets

available to fund this goal, the sub-portfolio assigned to goal 2 would be invested in growth-oriented assets

Curriculum Example: Consider the investors Ivy and Charles Ivy is a 54-year-old life science

entrepreneur Charles is a 55-year- old orthopedic surgeon They have two unmarried children aged 25 (Deborah) and 18 (David) Deborah has a daughter with physical limitations Four goals have been identified for the Lees:

1) Lifestyle/future consumption needs This goal is split into three components: required minimum

consumption requirements (a worst-case scenario of reduced lifestyle), baseline consumption needs (maintaining the current standard of living), and aspirational consumption needs (an improved standard of living)

2) College education for son David, 18 years old

3) Charitable gift to a local art museum in 5 years

4) Special needs trust for their granddaughter, to be funded at the death of Charles

The table below reflects the risk preferences assigned to these goals at age 54

Now, assuming that 20 years have passed, the Lees are now in their mid-70s, and their life expectancy is about 12 years Out of the four goals stated above, the two goals have been achieved, that is, their son has completed his college education and is successfully established in his own career and the charitable gift has been made

Further, since after 20 years, fewer future consumption years need to be funded, fewer assets would be needed to fund the baseline consumption goal The priority assigned to the goal to meet special needs trust for their granddaughter is still high

It is important to note that despite no change in risk preferences of Lees for these goals, the overall asset allocation will change because the total portfolio is an aggregated mix of the remaining goal-aligned sub-portfolios, weighted by their current present values Refer to the table below

Refer to Example 3 from the curriculum.

Time Diversification of Risk: Time diversification of risk refers to the belief that longer-horizon goals can

tolerate higher volatility In other words, since risky assets tend to reflect mean-reverting returns over intermediate to longer time horizons, the long-term goals and liabilities can be funded using higher risk/higher return assets This implies that as the time horizon shortens, the allocation to these riskier assets tends to decrease

2.4 Regulatory and Other External Constraints

An investor’s asset allocation can also be affected by local laws and regulations For example, if there are capital controls in any country, then the investors can not invest in non-domestic equities and bonds Institutional investors, including pension funds, insurance companies, sovereign wealth funds, endowments, and foundations, etc are subject to externally imposed constraints

 Need for capital to pay policyholder benefits: Insurance companies focus on matching assets to the

projected, probabilistic cash flows of the risks they are underwriting Therefore, the insurance company’s investment portfolio has a higher allocation in fixed-income assets

 Need to maintain financial strength ratings The types of investments in the investment portfolio do have an impact on financial ratings of insurance companies

Insurance companies may also have regulatory constraints associated with allocations to certain asset classes For example, the regulator may impose the maximum limit on equity exposure (say 10%) on insurance companies or may impose a limit or restriction on investing in real estate investments, non-publicly traded securities, private equity, allocation to high-yield bonds etc In general, insurance

regulators set a minimum capital level for each insurer based on that insurer’s mix of assets, liabilities, and risk

2.4.2 Pension Funds

Pension funds have regulatory and tax related constraints For example, in Japan, pension funds are required to hold a certain minimum percentage of assets in Japanese bonds in order to maintain their tax-exempt status

Pension funds are also subject to funding, accounting, reporting, and tax constraints that affect the asset allocation For example, US public pension funding and public and corporate accounting rules favor equity investments because higher equity allocations support a higher discount rate which results in lower pension cost

Refer to Exhibit 2 below Risk is defined as the probability of contributions exceeding some threshold amount The risk threshold is specified as the 95th percentile of the present value of contributions (using Monte Carlo simulation) where the plan sponsor can be 95% certain that contributions will not exceed that amount Portfolio A (70% equity/30% aggregate bond mix) has a present value (PV) of

expected contributions of approximately US$51 million (y-axis) and a 95% confidence level that

contributions will not exceed approximately US$275 million (x-axis) If pension fund chooses Portfolio D (comprising of longer-duration bonds) the PV of expected contributions declines by approximately US$5 million and the 95% confidence threshold improves to approximately US$265 million If pension fund chooses Portfolio D2 (60% equities/40% long bonds), the PV of expected contributions declines only marginally compared with Portfolio A (a lower equity allocation implies a lower expected rate of return, which increases the PV of contributions), however, the contribution risk also decreases (the 95%

confidence threshold improves to approximately US$245 million) because the lower equity allocation reduces the probability that less-than-expected returns will lead to unexpectedly large contributions

This implies that if plan’s sponsor’s objective is to reduce contribution risk, then he should prefer

Portfolio D2 to Portfolio A

2.4.3 Endowments and Foundations

Endowment or foundations are subject to the following two categories of externally imposed

constraints:

1) Tax incentives In some countries, foundations are subject to certain minimum spending

requirements in order to avail tax benefits or tax-favored status

2) Credit considerations Endowments or foundations may be constrained to limit the allocation to illiquid assets in order to support certain liquidity and balance sheet metrics specified by its

lender(s)

2.4.4 Sovereign Wealth Funds

In general, Sovereign Wealth Funds (SWF) are government-owned pools of capital invested on behalf of the peoples of their states or countries SWFs tend to have a long-term horizon

SWFs asset allocation decisions are also subject to regulatory related or cultural/religious related

constraints

 Regulatory constraints: For example, the Chilean SWF cannot invest more than 7% in equities; the Korean SWF cannot invest in Korean won-denominated assets; and the Norwegian SWF cannot invest in any alternative asset class other than real estate In addition, since SWFs are publicly owned, they tend to prefer lower-risk asset allocation despite their long-term horizon in order to avoid reputation risk

 Cultural or religious constraints: An example of a religious constraint is the Sharia law which

prohibits investment in any business that has links to pork, alcohol, tobacco, pornography,

prostitution, gambling, or weaponry, and interest payments (i.e banks and mortgage providers) etc Refer to Example 4 from the curriculum

This section addresses LO.b:

LO.b: discuss tax considerations in asset allocation and rebalancing;

3 ASSET ALLOCATION FOR THE TAXABLE INVESTOR

The pre-tax and after-tax risk and return characteristics of each asset class can be materially different Some assets are less tax efficient than others because of nature of their returns Generally, interest income incurs the highest tax rate, with dividend income taxed at a lower rate in some countries, and long-term capital gains receive the most favorable tax treatment in many jurisdictions Similarly, tax rules can be different depending on entities and accounts For example, retirement savings accounts may be tax deferred or tax exempt

Tax adjustments depend on the ultimate purpose of an asset For example, if investment portfolio’s goal

is to fund a future gift of appreciated stock to a tax-exempt charity, then capital gains tax may be

ignored altogether

3.1 After-Tax Portfolio Optimization

Portfolio optimization should be based on after-tax return and risk The expected after-tax return is defined in the following equation

rat = rpt(1 – t)

Where,

rat = the expected after-tax return

rpt = the expected pre-tax (gross) return

t = the expected tax rate

pa = the proportion of rpt attributed to price appreciation

td = the dividend tax rate

tcg = the capital gains tax rate

Taxes also affect the standard deviation assumption for each asset class The expected after-tax

standard deviation is defined in the following equation

σat = σpt(1 – t)

Where,

σat = the expected after-tax standard deviation

σpt = the expected pre-tax standard deviation

The above equation shows that taxes reduce both the after tax return and after tax risk (or losses) by the same (1 – t) tax adjustment

This implies that taxes tend to reduce both the expected mean return and the standard deviation of returns

Unlike risk and return, the correlations are not impacted by taxes

Curriculum Example: Let’s assume all investment assets are taxable and that cost bases equal current

market values Assume also that interest income is taxed at 40%, and dividend income and capital gains are taxed at 25% The asset classes include investment-grade (IG) bonds, high-yield (HY) bonds, and equity Exhibit 4, which shows the allocations for five different portfolios, P1 (lowest risk), P25, P50 (median risk), P75, and P100 (highest risk)—each on an efficient frontier comprised of 100 portfolios

We can observe from the chart below that P1 (low-risk portfolio) largely consists of IG bonds and taxes

do not have a significant impact on its asset allocation as reflected by the before tax and after asset allocation Similarly, for P100 (highest risk portfolio), taxes have no impact on the asset allocation In P50 (median risk portfolio), the before tax asset allocation has higher proportion invested in HY bonds but in the after tax asset allocation, the allocation to HY bonds decreases

There are two important takeaways from the above chart:

i Impact of taxes on asset allocation depends on the riskiness of the portfolio This implies that for very low or very high-risk portfolios, the impact of taxes on asset allocation is not significant However, when a portfolio is medium risk in nature, the impact of taxes on asset allocation is higher

ii Tax inefficient asset class are still important in an after-tax context when correlation with other asset classes is low IG and HY bonds are tax inefficient because the coupon income is typically taxed at a relatively higher rate (on annual basis) In contrast, in equities, the capital gains are taxed at a relatively lower rate and these taxes can also be deferred In above chart, the

allocation to HY bonds decreases in after-tax asset allocation because these HY bonds are risky and tax inefficient; whereas, the allocation to IG bonds is not impacted by a significant

percentage in the after-tax asset allocation compared with before tax asset allocation The reason being, Although IG bonds are tax inefficient, they have very low correlation with equities, and because of diversification benefits, they play an important role in asset allocation even after tax-adjustments

3.2 Taxes and Portfolio Rebalancing

For a taxable investor, more frequent rebalancing results in realized taxes; thus, the taxable asset owner should consider the trade-off between the benefits of tax minimization and the benefits of maintaining the targeted asset allocation by rebalancing

The rebalancing ranges for a taxable portfolio can be wider than those of a tax-exempt portfolio with a similar risk profile because the risk profile of a taxable portfolio is changed only by significantly larger movements in the asset class This is because the after-tax volatility is less than pre-tax volatility and asset class correlations remain the same With broader rebalancing ranges, the trading frequency is reduced and, consequently, the amount of taxable gains is also reduced

The equivalent rebalancing range for the taxable investor is derived as follows:

Rat=Rpt/(1 – t)

Where,

Rat = the after-tax rebalancing range

Rpt = the pre-tax rebalancing range

For example, if tax-exempt investor has 10% rebalancing range, then the equivalent rebalancing range for the taxable investor would be= 0.10/(1 – 0.25) = 13.3%

3.3 Strategies to Reduce Tax Impact

Tax-loss harvesting and strategic asset location can also be used to reduce taxes

 Tax-loss harvesting refers to intentionally trading to realize a capital loss, which is then used to offset a current or future realized capital gain in another part of the portfolio, thereby reducing the taxes owned by the investor

 Strategic asset location refers to placing (or locating) less efficient assets in accounts in exempt or tax-deferred accounts and placing tax efficient assets (low tax rates and/or deferred capital gains) in taxable accounts

tax-After-tax value of assets in a tax-deferred account is defined as below

vat = vpt(1 – ti)

Where,

vat = the after-tax value of assets

vpt = the pre-tax market value of assets

ti = the expected income tax rate upon distribution

General rule:

 Assets with lower tax rates and deferred capital gains (e.g equities) should be held in investor’s taxable accounts For example, equities should be held in taxable accounts

 Assets with higher tax rates (e.g taxable bonds) and high-turnover trading strategies should be held

in tax-exempt and tax-deferred accounts

 However, assets held for near-term liquidity needs should not be held in exempt and

tax-deferred accounts as these accounts may not be immediately accessible without tax penalty

Refer to Example 5 from the curriculum

This section addresses LO.c:

LO.c: recommend and justify revisions to an asset allocation given change(s) in investment

objectives and/or constraints;

4 REVISING THE STRATEGIC ASSET ALLOCATION

Strategic asset allocation (SAA) should be reviewed periodically even if there is no change in investor circumstances The circumstances that might trigger a special review of the asset allocation policy include the following:

 Change in economic environment; e.g., change in capital market expectations;

 Change in trustees or committee members: As new advisers or members join the Investment Committee, they bring their own beliefs and biases regarding certain investment activities

Glide path: This refers to anticipating changes in risk appetite and implementing pre-established

changes to asset allocation in response For example, assume an investor who is 40 years old and is expected to retire at the age of 65 As investor ages, human capital decreases and it is preferred to reduce allocation to risky assets and increase allocation to less risk assets, accordingly

Refer to Example 6 from the curriculum

This section addresses LO.d:

LO.d: discuss the use of short-term shifts in asset allocation;

5 SHORT-TERM SHIFTS IN ASSET ALLOCATION

Strategic asset allocation (SAA), or policy asset allocation, represents long-term investment policy targets for asset class weights Tactical asset allocation (TAA) represents short-term deviations from SAA targets based on cyclical variations within a secular trend (e.g., stage of business or monetary cycle) or temporary price dislocations in capital markets TAA is an asset-only approach TAA assumes that investment returns, in the short run, are predictable TAA uses short-term views or signals to re-weight the broad asset classes, sectors, or risk factor premiums It is important to note that TAA focuses on generating a positive return through market or factor timing rather than security selection

The success of TAA decisions can be evaluated in following three ways:

1) Comparing Sharpe ratio realized under the TAA relative to the Sharpe ratio realized under the SAA; 2) Evaluating the information ratio or the t-statistic of the average excess return of the TAA portfolio

relative to the SAA portfolio; and

3) Plotting the realized return and risk of the TAA portfolio versus the realized return and risk of

portfolios along the SAA’s efficient frontier This approach is particularly useful in assessing the adjusted TAA return

risk-Downside of TAA:

 TAA involves higher trading costs and taxes (in the case of taxable investors)

 TAA may also increase the concentration of risk of portfolio relative to the policy portfolio

Types of TAA: There are two broad types of TAA

 A large number of data points such as valuations, credit spreads, monetary and fiscal policy, GDP growth, earnings expectations, inflation expectations, and leading economic indicators

 Economic sentiment indicators

 Market sentiment indicators of the optimism or pessimism of financial market participants Market sentiment is gauged through margin borrowing, short interest, and a volatility index

 Margin borrowing indicates the current and future level of bullishness More buying on margin leads to higher prices Similarly, the aggregate level of margin can also indicate that bullish sentiment is overdone

 Short interest indicates the current and future bearish sentiments For example, rising short interest indicates increasing negative sentiment; a high short interest ratio may also indicate extreme pessimism that often occurs at market lows

 The volatility index (also known as fear index) indicates market expectations of near-term volatility VIX in the United States measures the level of expected volatility It rises when put option buying increases and falls when call buying activity increases

Discretionary TAA has an asymmetric return distribution because it is typically used to hedge risk in distressed markets while enhancing return in positive return markets

5.2 Systematic TAA

Systematic TAA seeks to exploit asset class level return anomalies that have been shown to have some predictability and persistence Systematic TAA uses value and momentum factors

 Value factor is the return of value stocks over the return of growth stocks

 Valuation ratios for equities include dividend yield, cash flow yield, and Shiller’s earnings yield (the inverse of Shiller’s P/E)

 Valuation signals for other asset classes include yield and carry in currencies,

commodities, and/or fixed income

 Momentum factor is the return of stocks with higher prior returns over the return of stocks with

lower prior returns It includes

 Trend following or time-series momentum: Under trend following, an asset class is

expected to continue in the same upward or downward trend that it has most recently exhibited For example, if an asset class exhibits upward direction in the most recent 12-month, then it is expected to persist for the next 12 months Another example is when the moving average of an asset class of the shorter time frame is above (below) the moving average of the longer time frame, then it signals an upward (downward) trend

 Cross-sectional momentum which shows the relative momentum returns of securities within the same asset class

Refer to Example 7 from the curriculum

This section addresses LO.e:

LO.e: identify behavioral biases that arise in asset allocation and recommend methods to overcome them;

6 DEALING WITH BEHAVIORAL BIASES IN ASSET ALLOCATION

The biases most relevant in asset allocation include loss aversion, the illusion of control, mental accounting, representative bias, framing, and availability bias

How to overcome? In goals-based investing, loss-aversion bias can be mitigated by

 framing risk in terms of shortfall probability (probability that a portfolio will not achieve the return

required to meet a stated goal);

 funding high-priority goals with low-risk assets Riskier assets can then be used to fund

lower-priority and aspirational goals

6.2 Illusion of Control

Illusion of Control Bias is a cognitive bias and it refers to having a false belief to have the ability to exert influence over uncontrollable events based on superior knowledge, skills It can be exacerbated by overconfidence bias and hindsight bias (considering past events as having been predictable)

Implications: This bias results in

 alpha seeking behavior and more frequent trading;

 concentrated portfolio positions;

 greater willingness to employ tactical shifts in the asset allocation

 underexposure to asset classes which are a significant part of the global market portfolio

How to overcome? This bias can be mitigated by

 using the global market portfolio as a starting point in developing global asset allocation

 following formal asset allocation process based on long-term forecasts

6.3 Mental Accounting

Mental accounting is an information-processing bias in which people classify money based on its source [that is, current income (e.g salary), currently-owned assets (e.g bonus), and the present value of future income (e.g inheritance)] or planned use (e.g leisure, necessities) This mental accounting bias can be reinforced by the endowment effect (exhibiting an emotional attachment to the asset owned)

Implications:

 Investors suffering from mental accounting bias fail to consider correlations between assets

assigned to different mental accounts which results in a suboptimal overall portfolio

 Investors suffering from representative bias exhibits return chasing behavior which results in

overweighting asset classes with good recent performance

Implications: