Behavioral Finance Chapter 3

Incorporating investor behavior into the asset

allocation process

If you don’t know who you are the stock market is an expensive
place to find out by Adam smith

Presented by :
Ahmed Tarek
Mustafa Elnady
Nada Saad
Incorporating Investor Behavior into the Asset
Allocation Process

This chapter explores the challenges faced in Wealth Management and the importance of integrating
Behavioral Finance into the asset allocation process by discusses the following;

● Underutilization of behavioral finance in wealth management

● Objectives of incorporating investor behavior
● Risk Tolerance Questionnaires
● Limitations of Risk tolérance questionnaires
● How to identify behavioral biases with clients
● How to apply bias diagnose when structuring asset allocation
● Principles of asset allocation strategy Principle 1 & 11
● Distinction between cognitive and emotional biases
● Incorporating behavioral finance in Asset Allocation
Challenges in Wealth Management and Behavioral
Finance

Wealth Management Challenges Need for Coping Mechanisms

Wealth management involves complex To navigate the challenges in wealth
decision-making processes that are susceptible management, both advisors and investors
to biases, leading to irrational financial require tools and coping mechanisms to
decisions resulting in suboptimal outcomes, recognize and mitigate behavioral biases.
factors include;
By understanding these biases and
● Overconfidence implementing strategies to counteract them,
● Loss aversion wealth managers can help investors make more
● Herding behavior rational and informed financial decisions.

Recognizing and addressing these challenges is

crucial for effective wealth management
Underutilization of Behavioral Finance in Wealth
Management

Lack of Practical Application Identification and Adaptation

● Behavioral finance is underutilized in ● Once an investor ‘s behavioral biases

wealth management due to lack of user- have been identified , advisors lack
friendly context and practical guidelines pragmatic guidelines for tailoring the
for adjusting asset allocation asset allocation process to reflect the
● Hence; the need to bridge the gap specific bias.
between academic research and real- ● Hence, Wealth managers need practical
world application, enabling advisors to guidelines for identifying biases and
effectively integrate behavioral finance adjusting asset allocation
principles into their practice strategies/investment decisions
accordingly.
● when to moderate or counteract biased
client reasoning and when to adapt
asset allocation recommendations.
Objectives of Incorporating Investor Behavior

Familiarization with Biases - Familiarize financial advisor and investors with 20

major behavioral biases that are relevant to the asset
allocation process
- By understanding these biases, advisors can better
anticipate and address potential pitfalls in their clients'
decision-making

Moderation vs. Adaptation - Advisors must navigate a delicate balance between

Moderating biases and Adapting strategies to align
with their clients' comfort levels
- Provide insights into when it is appropriate to
counteract biases and when it is more effective to
adapt investment strategies to accommodate clients'
psychological preferences
Risk Tolerance Questionnaires

● For compliance reasons , Financial service firms require their advisors to perform and record risk tolerance

questionnaires to clients and potential clients prior to drafting any asset allocation.

● In the absence of any other diagnostic analysis, this methodology is certainly useful and generates important

information about the investor, However, it is important to recognize the limitations of risk tolerance

questionnaires.

● From the behavioral Finance perspective, risk Tolerance questionnaires may work well for institutional investors

but fail regarding psychologically biased individuals.

Limitations of Risk Tolerance Questionnaires

Imprecision Overinterpretation Behavioral Inadequacy

● William Sharpe, a Nobel Prize winner, ● Advisors may fall into ● Risk tolerance
criticizes the use of these questionnaires often fall
the trap of
questionnaires, arguing that they don't
overinterpreting short when dealing with
significantly impact portfolio design.
questionnaire results, psychologically biased
● May yield inconsistent results due to
variations in question wording and the relying solely on these individuals leaving behind
lack of revisits assessments to guide the behavioral aspects of
● Can lead to inaccurate assessments of their asset allocation decision-making, potentially
clients' risk tolerance, potentially decisions, failing to leading to poor investment
resulting in unsuitable portfolio capture the full decisions for clients
recommendations. complexity of clients'
risk preferences leading
to inaccurate portfolio
parameters
How to identify behavioral biases with clients

• Bias can be divided to 20 prominent biases (cognitive and emotional), along with
strategies for identifying and applying them in client relationships. In general,
biases are diagnosed by means of a specific series of questions.
• Some bias chapters will contain a list of diagnostic questions to determine
susceptibility to each bias. In other chapters, more of a case-study approach is used
to determine susceptibility.
• In real life, biases are diagnosed by means of a specific series of questions.
Therefore, identifying biases will improve the quality of advice to investor, when
taking into account behavioral factors.
How to apply bias diagnose when structuring asset
allocation
• when considering behavioral biases in asset allocation, financial advisors must
first determine whether to moderate or to adapt to “irrational” client
preferences.
• The principles laid out in this section offer guidelines for resolving the puzzle
“When to moderate, when to adapt?”
• In applying behavioral finance , practitioners must decide whether to attempt to
change their clients’ biased behavior or adapt to it.
• They should adapt to emotional biases and moderate cognitive biases These
actions will lead to a client’s best practical allocation
Principle 1 : moderate biases in less-wealthy clients;
Adapt to biases in wealthier clients
• Practitioners should adapt to biases at high wealth levels ( wealthy client ) and attempt to
modify behavior at lower wealth levels (less- wealthy clients).
• Because wealthy client ,given their higher level of wealth, the potential impact of behavioral
biases may be less severe, allowing for more flexibility in adapting to them
• On the other hand, Financial advisors should work to modify the behavioral biases of less-
wealthy clients. This involves educating them about common biases and providing guidance
on making rational decisions. Since the financial consequences of behavioral biases can be
more significant for less-wealthy clients, it is essential to help them overcome these biases
and make better investment choices.
Principle 11 : Moderate cognitive biases; Adapt to
Emotional biases

Advisor should adapt to emotional biases and moderate cognitive biases. These actions will
lead to a client’s best practical allocation .
Cognitive biases, which are based on faulty reasoning, can be corrected with better information
and advice. Emotional biases, on the other hand, are difficult to rectify due to their origin from
impulse or intuition. These principles also reveal that two clients with the same biases should
sometimes be advised differently.
Cognitive vs. Emotional Biases

Cognitive Biases Emotional Biases

Cognitive biases arise from faulty reasoning and Emotional biases, on the other hand, result from
information processing, such as; impulsive and emotional responses they are often
harder to rectify as they stem from deep-seated
● Anchoring and adjustment bias psychological factors, such as;
● Availability and representativeness bias
● Ambiguity aversion ● Loss aversion
● Self –attribution
● Conservatism ● Endowment
● Self-control

While cognitive biases can lead to suboptimal decision- Understanding and addressing these biases is crucial
making, they can often be corrected with better for managing investor behavior effectively.
information and awareness.
Incorporating investor behavior into the Asset
Allocation Process
Visual Depiction of Principles I and II
Quantitative Guidelines for incorporating
behavioral finance in Asset Allocation

● Mean-Variance Optimization : Standard asset allocation strategies often rely on mean-variance optimization,

which focuses on maximizing returns while minimizing volatility. However, these traditional approaches may

not fully account for the psychological biases that influence investors' decision-making processes

● A suggested technique for determining the extent of a reasonable discretionary departure from the mean-

variance output allocation's default is as follows. A behaviorally adjusted allocation shouldn't deviate from

the mean-variance-optimized allocation by more than 20% from mean-variance-optimized allocation.

● The rationale for the 20 percent figure is that most investment policy statements permit discretionary asset

class ranges of 10 percent in either direction.

● A basic algorithm is provided to determine how sizable an adjustment could be implemented without

departing too drastically from the relevant mean-variance-optimized allocation.

Quantitative Guidelines for incorporating
behavioral finance in Asset Allocation

Method for Determining Appropriate Deviations from the Rational Portfolio

1.Subtract each bias-adjusted allocation from the mean-variance out- put.

2.Divideeachmean-varianceoutputbythedifferenceobtainedinStep1. Take the absolute value.

3.Weight each percentage change by the mean-variance output base. Sum to determine bias

adjustment factor.

Ex.
Conclusion of Incorporating Investor Behavior into
Asset Allocation

Focus on Practical Application Future Exploration

● Incorporating investor behavior into ● As the field of behavioral finance

asset allocation requires a focus on continues to evolve, there is a need for
practical application rather than further exploration of case studies and
theoretical distinctions strategies for incorporating behavioral
● The emphasis should be on finance into wealth management
understanding real-life biases and their practices
implications for asset allocation ● By studying real-world examples and
decisions developing practical strategies, advisors
● By applying this knowledge, advisors can further enhance their ability to
can create investment strategies that effectively incorporate investor behavior
align with clients' behavior and optimize into the asset allocation process, leading
their portfolio performance. to better outcomes for their clients