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Behaviorally Modified Asset Allocations for Passive Preservers

When to maintain a rational asset allocation and when to give in to behavioral biases.

Michael M. Pompian, 02/18/2010

In the last two articles, we learned several important concepts as it relates to creating behaviorally modified asset allocations, or BMAA (also referred to as best practical allocation). We learned that in order to develop proper guidelines for applying biases to asset allocation decisions, advisors must answer a central question: when should I, as the advisor, attempt to change the way my client is behaving (i.e., regulate the effects of behavioral biases) to match an asset allocation I believe is correct for them, and when should I adapt the asset allocation recommendation to match the client's behavioral profile? To answer that question, we learned two guidelines. Guideline one said that the decision to regulate or adapt to a client's behavioral biases during the asset allocation process depends in large part on the client's wealth level. Specifically, the wealthier the client, the more the advisor is safely able to adapt the asset allocation to the client's behavioral biases. The less wealthy, the more the advisor should attempt to regulate a client's biased behavior to match a rational asset allocation. Guideline two said that the decision whether to regulate or adapt to a client's behavioral biases during the asset allocation process also depends fundamentally on the type of behavioral bias being exhibited by the client. Specifically, clients exhibiting cognitive biases, which stem from illogical reasoning, can be regulated, while those clients exhibiting emotional biases, which stem from impulsive feelings, should be adapted to.

We will now put these ideas into concrete action by examining each behavioral investor type and how one might think about creating a BMAA for each one. We will begin with the Passive Preserver (PP). Our process will be to review the basics of each BIT (today will be the PP), discuss the primary biases at work and how we incorporate these biases into our allocation recommendation, and then discuss how to modify an asset allocation based on these biases. Note that in this exercise we will not be examining standard of living risk. We will tie that concept in later in subsequent articles.

Review of Passive Preservers
PPs place a great deal of emphasis on financial security and preserving wealth rather than taking risk to grow wealth. Some PPs obsess over short term performance and are slow to make investment decisions because they aren't entirely comfortable with change - which is consistent with the way they have approached their professional lives - being careful not to take excessive risks. Many PPs are focused on taking care of their family members and future generations, especially funding life-enhancing experiences such as education and home buying. Because the focus is on family and security, PP biases tend to be emotional rather than cognitive. As age and wealth level increase, this BIT becomes more common. Behavioral biases of PPs tend to be security-oriented biases such as endowment bias, loss aversion, status quo and regret. PPs also often exhibit cognitive biases such as anchoring and mental accounting.

Scenario
Suppose you are beginning an engagement with a new client, Stan. You give him a standard of risk tolerance quiz and determine that he is a conservative investor. After that, you give him a test for behavioral biases of conservative clients. Based on the answers to the bias questions you determine that Stan is a PP. Some of your other clients are conservative but they are not biased like Stan. The object of this exercise is to see how to create a BMAA for a PP versus a non- or mildly-biased conservative investor. Generally, this can mean that a PP should accept less risk in his portfolio than those clients without bias. Since Stan is a passive preserver, he is not predisposed to taking on additional risk to his portfolio anyway. This makes working with PP an easier task than with some other BITs.

The following analysis presents two investment programs, one for Steve (a non-biased conservative investor) and one for Stan (a PP).  You are using Steve's portfolio allocation as a baseline for creating Stan's. Your basic task as to assess a retirement goal for Stan and the associated risk associated with the return needed to reach that goal. When working with actual clients, you will need to adjust this analysis to suit your purposes.

Passive Preserver (Stan) versus non-biased conservative investor (Steve)

As we know, PP clients:
* are driven by emotion;
* generally want a very conservative portfolio anyway.

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