CFA 2018 level 3 gostudy behaviorally modified asset allocation (r7)

Behaviorally Modified Asset Allocation Strategies Reading 7 Understanding that individual investors are imperfect and subject to various biases, some of which may be very difficult to mi

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Contents

Behaviorally Modified Asset Allocation Strategies (Reading 7) 4

Goal Based Investing 4

Behaviorally Modified Asset Allocation 4

Behavioral Finance and Investment Processes 6

Three Behavioral Models for Classifying Investors 6

Barnewell 2-way Model 6

Bailhard, Biehl, & Kaiser (BB&K) Five Way Model 7

Pompian Behavioral Model 7

Summarizing the Traditional vs Behavioral Classifications 8

Behaviorally Modified Asset Allocation Strategies (Reading 7)

Understanding that individual investors are imperfect and subject to various biases, some of which may be very difficult to mitigate, behavioral finance offers portfolio strategies that can lead to acceptable (if not optimal) outcomes The end goal is to get as close to efficient as

possible while also designing something the individual can understand and stick with The key, however, is that the degree to which an investment manager can accommodate an individual’s quirks depends on the degree of financial risk that individual is able and willing to take

We recommend skimming a few IPS questions in the morning mock exams following this reading

to get a sense of how behavioral finance will be tested in the constructed response section, as well as what types of information will be given in a passage for you to determine SLR The examples in the curriculum aren’t particularly helpful for how you’ll get tested on this

Goal Based Investing

Similar to Behavioral Portfolio Theory, the idea here is to build the portfolio layer by layer to meet different goals You start with the base of the pyramid which are lower risk assets designed

to meet key spending needs As you move up the pyramid, you take greater risks to meet less

essential needs That is, there is an inverse relationship between risk and level of need

While GBI will likely lead to a fairly diversified portfolio it is still inefficient in the traditional sense This is because each level of the pyramid is constructed (“individually justified”) with no thought to the correlation between the asset classes This of course flies in the face of modern portfolio theory

Behaviorally Modified Asset Allocation

BMAA is a strategy that looks to integrate as many elements of traditional portfolio theory as possible while also acknowledging that clients aren’t perfect Thus BMAA creates some freedom for clients to deviate from the optimal efficient (rational) portfolio while still striving to design

an investment strategy that lies as close to the efficient frontier as possible

Ultimately those tradeoffs are all about creating a portfolio clients understand so that they can live with through ups and downs of the market This is more vital than achieving a “perfect” asset allocation because taking any action at an inopportune time can be especially devastating to

a portfolio (take for example selling everything at the very bottom of a market)

To use BMAA we:

1 Start with the traditional approach

2 ID the client’s financial situation

a > Wealth = > Degree to which quirks can be tolerated (see Standard of Living Risk

3 ID the nature of their cognitive & emotional biases

a Cognitive biases are easier to mitigate, emotional you often accommodate

4 Measure client’s wealth relative to their lifestyle to measure their standard of living

risk 1

5 Establish the standard deviation from optimal allocation

BMAA Accommodation based on biases and Standard of Living Risk (SLR)

Basically, the more assets you have to cover your standard of living, the more an advisor can accommodate behavioral quirks Always remember, cognitive errors are easier to correct

whereas emotional biases often have to be accommodated You probably won’t need to know the target acceptable deviation percentages but here’s a sense of accommodation vs modification in terms of SLR:

 Low SLR/High Wealth & emotional bias: Accommodate; 10-15% deviation allowable

 Low SLR/High Wealth & cognitive bias: Accommodate & moderate; 5-10% deviation

 High SLR/Low Wealth & emotional bias: Accommodate & moderate; 5-10% deviation

 High SLR/Low Wealth * cognitive bias: Moderate; 0-3% deviation target

1 Risk that the current or specified lifestyle may not be sustainable

For the exam keep in mind that SLR and the degree of wealth is a matter of perception If a

client’s financial needs are low and they have no wish to increase their spending they may well have a low SLR and high amount of wealth relative to their needs despite a “low” asset base

Behavioral Finance and Investment Processes

For the exam you should be able to classify an investor according to the Barnewell 2-way model, the BB&K mode, or the Pompian model according to given information You will also need a thorough understanding of the IPS, why it is so important, and how it is constructed

From the perspective of the CFAI curriculum the end goal of all this behavioral finance stuff is

to improve the advisor/client relationship There are four main goals:

1 Getting the advisor to understand the long range financial goals of the client

2 Getting the advisor to maintain a consistent approach

3 Having the advisor act as the client expects

4 Creating a mutually beneficial relationship between the advisor and client

Before we go over the actual investor classification schemes, let’s list the limitations to

classifying investors at all

Limitations to Behavioral Classifications

 Individuals can exhibit emotional and cognitive biases at the same time

 An individual can display traits of more than one behavioral investor type

 As investors age or have different life circumstances they will go through different

behavioral changes

 Even individuals in the same classification are still unique people with own traits

 Individuals tend to act irrationally at unpredictable times limiting the usefulness of any given model

Three Behavioral Models for Classifying Investors

In order for the advisor to hit all four of their goals in understanding their clients they need to know what type of investor they are dealing with To this end, the curriculum lays out three behavioral models to help in identifying the type of client you are working with

Barnewell 2-way Model

Active Investors: Have usually risked their own capital to gain wealth (entrepreneurs) They

usually take an active role in investing their own money More experienced, more comfortable with risk, particularly while they feel in control of that risk

VS

Passive Investors: Have NOT risked their own capital to gain wealth May have less education

about investing & risk averse/cautious On the exam passive investors will either be inheritors or

long-term savers who have saved $ from a steady job

Bailhard, Biehl, & Kaiser (BB&K) Five Way Model

This model builds on some of the principles of the Barnewell classification scheme but classifies

investors based on two axes: How confident they are (the Y Axis) and how carefully they

consider decisions and act on them (the X Axis) This yields 5 investor types (the “Straight

Arrow” is a blend of each): The model is best encapsulated by the following graph:

The BB&K Five Way Model

Pompian Behavioral Model

The Pompian Behavioral Model divides investors into four different types An advisor

determines the Investor’s behavioral type (BIT) through a four step process (which isn’t

important to know) The steps are:

1 Interview client to determine if they are active or passive (as a proxy for risk

tolerance)

2 Plot the investor on a risk tolerance scale

3 Test for behavioral biases

4 Classify into one of the four categories

These four categories are:

 The passive preserve

 The friendly follower

 The independent individualist

 The active accumulator

The different risk tolerance, investment styles are summarized in the following table (You should see many parallels to the BB&K model):

Profile of Pompian Investor Types

Investor Type Risk

Tolerance

Investment Style

Dominant Bias

Types of Emotional Bias

Types of Cognitive Bias

Passive

Preserver Low Conservative Emotional

endowment, loss/regret aversion, status quo

Mental accounting, anchoring & adj

Friendly

Follower

↓ ↓

Cognitive Regret Aversion Availability,

Hindsight, Framing

Independent

Individualist Cognitive

Overconfidence, Self-attribution

Conservatism, availability, confirmation, representativeness Active

Accumulator High Aggressive Emotional

Overconfidence, self-control Illusion of control

For the exam you should be comfortable identifying an investor’s profile, possibly only based on information about the types of biases they display

Summarizing the Traditional vs Behavioral Classifications

This table is actually summarizing some of the information presented in the beginning of the next reading, Reading 8 on managing individual investor portfolios

Let’s summarize one more time the differences between traditional and behavioral models for

portfolio construction:

Traditional vs Behavioral Portfolio Construction

Risk Averse – Maximize Return for Given Risk

Level Loss Aversion Rational Expectations – Forecasts are unbiased

and reflect all info Biased Expectations

Asset integration – Consider total portfolio risk

and asset correlation Asset segregation (mental accounting) Portfolio constructed holistically using weighted

avg and correlation

Individual Preferences & layered portfolio

construction

Mind-mapping the Three Behavioral Models

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