Psychological influences on investor decisions A behavioral finance approach to strategic asset allocation Jean L.P. Brunel, C.F.A The CFA Society of Victoria

Psychological influences on investor decisions

A behavioral finance approach to strategic asset allocation

Jean L.P. Brunel, C.F.A

The CFA Society of VictoriaVictoria, BC

September 21st, 2010

Three main points …

The inadequacy of current approaches:

A different model:

A practical application:

Current approaches

involve heavy

quantitative input

based on highly

qualitative data … We

do not speak the

same language

…

x

x

xx

E[r]

Time

Index Values (USD)

Compound Growth of Assets

400,000,000

2,000,000,000

1,000,000,000

906,591,154

836,568,109

645,925,289

515,550,842

Jun1995

Sep2003

Dec1995

Jun1996

Dec1996

Jun1997

Dec1997

Jun1998

Dec1998

Jun1999

Dec1999

Jun2000

Dec2000

Jun2001

Dec2001

Jun2002

Dec2002

Returns Histogram

Return

Number

Returns Histogram

-4.0% 10.0%-2.0% 0.0% 2.0% 4.0% 6.0% 8.0%0

28

2468

101214161820222426

Time

WeightsArea Graph for Arden Institutional Advisors - Estimated Weights

Rolling Style Distribution

0.0%

100.0%

10.0%20.0%30.0%40.0%50.0%60.0%70.0%80.0%90.0%

Oct1995

Sep2003

Dec1996

Dec1997

Dec1998

Dec1999

Dec2000

Dec2001

Dec2002

HFRI Convertible Arbitrage TR HFRI Distressed Securities TRHFRI Emerging Markets TR HFRI Equity Hedge TRHFRI Equity Market Neutral TR HFRI Event-Driven TRHFRI Fixed Income Arbitrage TR HFRI Macro TRHFRI Merger Arbitrage TR HFRI Relative Value Arbitrage TRHFRI Short Selling TR HFRI Statistical Arbitrage TR

The inadequacy of current tools …

What is the problem?

The process is driven by

an apparent

desire to fit each

investor into the

same set mold …

Highly quantitative results, based on rough answers

No focus on the way the individual views the problem

Jargon overload

What is missing?

A healthy and meaningful interaction

A solution based on:o What “I,” the investor, want … ando How “I” want it

In short, a solution:o With which I can associateo and with which I can live over time

An alternative model

Imagine a completely

different approach,

one starting with the

investor…

Describing investors goals:o think of a menu of dishes, …o not of a menu of ingredients

Prioritizing and dollar weighting them:

Constructing appropriate sub-portfolios:o To “defease” each goalo 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 investors

usually have three

distinct generic

goals that competes

for their attention …

Personal:o Meet current and unanticipated needso Maintain future flexibility

Dynastic:o How much should my children get?o What about generations beyond them?

Philanthropic: o Active or passive philanthropyo Philanthropy as a family value

The behavioral finance portfolio …

This design, initially

proposed by Meir

Statman, illustrates

the fact that we

have different views of risk for

different goals …

Investment risk

Aggressive Strategies

Balanced Growth Portfolio

Balanced Portfolio

Tax-efficient, conservativePortfolio. Risk taken

Only to preserve long-term purchasing power

Lifestyle

Shelter and food

PassivePhilanthropy

Dynastic

Changes in dynastic/life-style and active philanthropy

Dynastic

Philanthropic

Personal

Flexibility


Disutility of losses vs. utility of gains:o Downside risk minimization

Behavioral finance theory

helps us understand

how investors

behave rather than

tell how they should

behave…


Disutility of losses vs. utility of gainso Downside risk minimization

Limited framing and hindsight biases:o Reactive decision mode


helps us understand

how investors

behave rather than


behave…



Limited framing and hindsight biaseso Reactive decision mode

Overconfidence and illusion of control:o Momentum style


helps us understand

how investors

behave rather than


behave…




Overconfidence and illusion of controlo Momentum style

Regrets:o Changing horses in mid race


helps us understand

how investors

behave rather than


behave…



helps us understand

how investors

behave rather than


behave…



Overconfidence and illusion of controlo Momentum style

Regretso Changing horses in mid race

Asset class or strategy prejudice

Goal-based asset allocation …

How do you pick

you meal in a

restaurant? From a

menu of dishes or a

menu of ingredients

?

Identify goals with which we can associate:o Liquidityo Incomeo Capital preservationo Growth


Identify goals with which we can associateo Liquidityo Incomeo Capital preservationo Growth

Structure sub-portfolios for each goal:o Manageo Report


Identify goals with which we can associateo Liquidityo Incomeo Capital preservationo Growth

Structure sub-portfolios for each goalo Manageo Report

Consider the full picture as a fiduciary

Operating businesses

Opportunistic investments or trades

Collectibles

Others

We need to remain flexible in designing

these goals, as

an investor

might prefer

others …

Four goals and more…

The process, in short …

Describe the main goals of our investor

Structure a sub-portfolio for

each goal

Dollar weigh and prioritize these

goals

Optimize these portfolios across

the whole

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

portfolio is poorly

constructed with little alternative

asset exposure

and much too much

cash…Current expected AT return: 7.4%Current expected AT volatility: 8.1%

Current Portfolio Allocation

Cash & Related

Fixed Income

Non-Directional Multi-Strategy

Traditional Equities

Private Equity

Semi-Directional Multi-Strategy

Real Assets

19.9%2.7%

42.5%

10.4%4.8%

9.9% 9.8%


Liquidity: $1 milliono AT spending needs for a year

The first step is to

create the appropriate

“bucket” exposures.


Liquidity: $1 milliono AT spending needs

Income: $8.2 milliono To defease $1 mil/year for 10 year, 2% CPIo Assumes a 5.5% after tax return



Income: $8.2 milliono To defease $1 mil/year for 10 year, 2% CPI

Capital preservation: $5.4 milliono To defease spending needs for years 11-20o Assumes a 6.1% after tax return




Capital preservation: $5.4 milliono To defease spending needs for years 11-20

Real assets: $4.9 million





Real assets: $4.9 million

Growth: $30.6 million


The growth portfolio allows:o Compounding for the futureo Early philanthropic givingo Early generational transfers

Note the size of the

“growth” sub-

portfolio…


The growth portfolio allowso Compounding for the futureo Early philanthropic givingo Early generational transfers

Income and capital preservation can beo Allowed to “mature” o Topped up and rebalanced annually

Note the size of the

“growth” sub-

portfolio… and the

allocation can be

viewed in dynamic terms …

Back to the case study …




Growth: $30.6 million + $4.9 in real assets


Optimized Bucket AllocationNote that each sub-

portfolio makes sense,

relative to its own

basic goal …

Liquidity

100.0%

Cash &Related

Income

75.0%

25.0%Fixed Income

Non-DirectionalMulti-Strategy

Capital Preservation

10.0%

45.0%30.0%

5.0%10.0%

Semi-DirectionalMulti-Strategy

Real Assets

Growth

12.5%

40.0%10.0%

37.5%TraditionalEquities

Private Equity


The newly allocated portfolio satisfies

their individual

goals more closely,

and seems much more efficient in

financial terms …

Expected AT return: 8.3% (+0.9%)Expected AT volatility: 7.3% (-0.8%)

Optimized Portfolio Allocation

Cash & Related

Fixed Income

Non-Directional Multi-Strategy

Traditional Equities

Private Equity

Semi-Directional Multi-Strategy

Real Assets

2.8%

24.5%

6.4% 25.6%

14.4%

16.0%10.2%

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 yearo Various buckets are rebalancedo Until no need to keep thinking that way …o Risk = over-exposure to low risk assets

Combining all in one …

This overall portfolio

seems to make

sense, particularly

when one looks at

return and risk

expectations per sub-portfolio …

Capital OverallLiquidity Income Preservation Growth Portfolio

Expected P T Compound Return 6.08% 8.32% 8.84% 10.98% 10.26%Expected A T Compound Return 3.95% 5.45% 6.02% 9.04% 7.98%Expected Risk (Pretax) 4.06% 5.27% 4.10% 11.53% 8.15%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 1.26Return per Unit of Risk (After-Tax) 1.50 1.58 2.17 0.88 1.13Sharpe Ratio (Pretax) 0.49 0.80 1.16 0.60 0.76Probability 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%

Each bucketo Reinforces validity of choice

Aggregateo Meets goals in an understandable manner

Introducing asset location …

Optimized Asset LocationNote the scope for

asset location

flexibility and that the tax-exempt pocket

comprises tax-

inefficient strategies

…

Taxable

27.1% 15.9%6.9%

27.0%

0.6%

19.1%

3.5%

Tax-Exempt

63.0%

25.3%11.7%

Cash & Related

Fixed Income

Non-DirectionalMulti-Strategy

TraditionalEquities

Private Equity

Semi-DirectionalMulti-Strategy

Real Assets

Three unintended benefits …

More sensible tactical rebalancingo Each move makes sense within sub-portfolioo Bet size consistent with goal breakdown

Promotes better advisor-client dialogo Income needs in relation to assetso Funding of very large asset purchases

Well suited to the use of FLP’s:o FLP focused on goal, not asset classo Allocation variations across generations

The current environment …

Dealing unusual conditionso Managing decision risk is realo What if capital market theory had holes?

Varying the definition of bucketso Goals versus fearso Intermediate versus long term

Same issue: “relating to one’s portfolio”o Understanding the languageo 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 timeso Fundamentally requiredo Emotionally necessary

Psychological influences on investor decisions

A behavioral finance approach to strategic asset allocation

Jean L.P. Brunel, C.F.A

The CFA Society of VictoriaVictoria, BC

September 21st, 2010

Documents

Psychological influences on investor decisions A behavioral finance approach to strategic asset allocation Jean L.P. Brunel, C.F.A The CFA Society of Victoria