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

www.gostudy.io Go Study’s CFA Exam Level ® Behaviorally Modified Asset Allocation Strategies by GoStudy™ www.gostudy.io Everything you need to pass & nothing you don’t www.gostudy.io Guided Notes for CFAđ Level 2016 Copyright â 2016 by Go Study LLC.® All Rights Reserved Published in 2016 The “CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute CFA Institute does not endorse, promote, review, or warrant the accuracy of the products or services offered by www.gostudy.io Certain materials contained with this text are the copyrighted property of the CFA Institute The following is the copyright disclosure for those materials: “Copyright, 2016, CFA Institute Reproduced and republished from 2016 Learning Outcome Statements, Level III CFA® Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institute’s Global Investment Performance Standards with permission from CFA Institute All rights reserved.” Disclaimer: These guided notes condense the original CFA Institute study material into 300 pages It is not designed to replace those notes, but to be used in conjunction with them While we believe we cover all of the core concepts accurately we cannot guarantee nor warrant that this is true Use of these notes is not a guarantee of exam success (although we think it will help a lot) and we cannot be held liable for your ultimate exam performance About gostudy.io Along with these Guided Notes, GoStudy offers a suite of products for in-depth exam strategies and comprehensive subject review to help candidates pass the final CFA exam We have hundreds of notecards and practice problems built into a mobile app for on-the-go review, with detailed analytics (coming), and last-minute cram material such as equation lists and “week before” summary sheets We also highly recommend candidates subscribe to our free newsletter for exclusive offers, access to study tips, tricks, and in-depth discussions of the exam We also periodically provide bonus resources such as mock exams, practice problems, and more to our subscribers If you have any questions regarding this product, the exam, or how we can help please contact us via the website We strive to answer every question a candidate has and are always incorporating Candidate feedback into what we build next www.gostudy.io Contents Behaviorally Modified Asset Allocation Strategies (Reading 7) Goal Based Investing Behaviorally Modified Asset Allocation Behavioral Finance and Investment Processes Three Behavioral Models for Classifying Investors Barnewell 2-way Model Bailhard, Biehl, & Kaiser (BB&K) Five Way Model Pompian Behavioral Model Summarizing the Traditional vs Behavioral Classifications www.gostudy.io 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) www.gostudy.io To use BMAA we: Start with the traditional approach ID the client’s financial situation a > Wealth = > Degree to which quirks can be tolerated (see Standard of Living Risk ID the nature of their cognitive & emotional biases a Cognitive biases are easier to mitigate, emotional you often accommodate Measure client’s wealth relative to their lifestyle to measure their standard of living risk1 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 Risk that the current or specified lifestyle may not be sustainable www.gostudy.io 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: Getting the advisor to understand the long range financial goals of the client Getting the advisor to maintain a consistent approach Having the advisor act as the client expects 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 www.gostudy.io 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 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: Interview client to determine if they are active or passive (as a proxy for risk tolerance) Plot the investor on a risk tolerance scale Test for behavioral biases Classify into one of the four categories These four categories are:  The passive preserve  The friendly follower  The independent individualist  The active accumulator www.gostudy.io 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 Passive Preserver Friendly Follower Independent Individualist Active Accumulator Risk Tolerance Types of Dominant Bias Types of Emotional Bias Emotional endowment, loss/regret aversion, status quo Mental accounting, anchoring & adj Cognitive Regret Aversion ↓ ↓ Availability, Hindsight, Framing Cognitive Overconfidence, Self-attribution Conservatism, availability, confirmation, representativeness High Emotional Overconfidence, self-control Illusion of control Low Investment Style Conservative Aggressive Cognitive Bias 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 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 Traditional Behavioral Risk Averse – Maximize Return for Given Risk Level Loss Aversion Rational Expectations – Forecasts are unbiased and reflect all info Biased Expectations www.gostudy.io 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 Want more notes? Get them plus a study app + cram guides + equation sheets + mock exams and more www.gostudy.io Questions? Email vsowers@gostudy.io ... what we build next www .gostudy. io Contents Behaviorally Modified Asset Allocation Strategies (Reading 7) Goal Based Investing Behaviorally Modified Asset Allocation ...www .gostudy. io Guided Notes for CFA Level – 2016 Copyright © 2016 by Go Study LLC.® All Rights Reserved Published in 2016 The CFA and Chartered Financial Analyst® are trademarks owned by CFA. .. Summarizing the Traditional vs Behavioral Classifications www .gostudy. io Behaviorally Modified Asset Allocation Strategies (Reading 7) Understanding that individual investors are