Behavioral Finance and Wealth Management

The book that applies behavioral finance to the real world

Understanding how to use behavioral finance theory in investing is a hot topic these days. Nobel laureate Daniel Kahneman has described financial advising as a prescriptive activity whose main objective should be to guide investors to make decisions that serve their best interests. The reality? That's easier said than done. In the Second Edition of Behavioral Finance and Wealth Management, Michael Pompian takes a practical approach to the growing science of behavioral finance, and puts it to use for real investors. He applies knowledge of 20 of the most prominent individual investor biases into "behaviorally-modified" asset allocation decisions. Offering investors and financial advisors a "self-help" book, Pompian shows how to create investment strategies that leverage the latest cutting edge research into behavioral biases of individual investors. This book:

• Shows investors and financial advisors how to either moderate or adapt to behavioral biases, in order to improve investment results and identifies "the best practical allocation" for investment portfolios. Using these two sound approaches for guiding investment decision-making, behavioral biases are incorporated into the portfolio management process
• Uses updated cases studies to show investors and financial advisors how an investor's behavior can be modified to improve investment decision-making
• Provides useable methods for creating behaviorally modified investment portfolios, which may help investors to reach their long term financial goals
• Heightens awareness of biases so that financial decisions and resulting economic outcomes are improved
• Offers advice on managing the effects of each bias in order to improve investment results

This Second Edition illustrates investors' behavioral biases in detail and offers financial advisors and their clients practical advice about how to apply the science of behavioral finance to improve overall investment decision making.

Preface xv

Acknowledgments xxiii

Part One Introduction to Behavioral Finance 1

Chapter 1 What Is Behavioral Finance? 3

Behavioral Finance: The Big Picture 4

Standard Finance versus Behavioral Finance 12

The Role of Behavioral Finance with Private Clients 19

How Practical Application of Behavioral Finance Can Create a Successful Advisory Relationship 19

Notes 21

Chapter 2 The History of Behavioral Finance Micro 23

Historical Perspective on the Link between Psychology and Economics 23

Modern Behavioral Finance 27

Psychographic Models Used in Behavioral Finance 36

Notes 40

Chapter 3 Introduction to Behavioral Biases 43

Introduction 43

Behavioral Biases Defined 44

Why Understanding and Identifying Behavioral Biases Is Important 45

Categorization of Behavioral Biases 46

Differences between Cognitive and Emotional Biases 46

Difference among Cognitive Biases 47

Emotional Biases 48

A Final Word on Biases 49

Summary of Part One 50

Part Two Belief Perseverance Biases Defined and Illustrated 51

Chapter 4 Cognitive Dissonance Bias 53

Bias Description 53

Practical Application 55

Research Review 57

Diagnostic Testing 59

Advice 60

Conclusion 62

Notes 62

Chapter 5 Conservatism Bias 63

Bias Description 63

Practical Application 64

Research Review 67

Diagnostic Testing 69

Advice 70

Notes 71

Chapter 6 Confirmation Bias 73

Bias Description 73

Practical Application 75

Research Review 77

Diagnostic Testing 81

Advice 83

Notes 84

Chapter 7 Representativeness Bias 85

Bias Description 85

Practical Application 87

Research Review 89

Diagnostic Testing 93

Advice 94

Notes 97

Chapter 8 Illusion of Control Bias 99

Bias Description 99

Practical Application 100

Research Review 103

Diagnostic Testing 104

Advice 105

Final Thought 106

Notes 106

Chapter 9 Hindsight Bias 107

Bias Description 107

Practical Application 108

Research Review 109

Diagnostic Testing 112

Advice 113

Notes 114

Part Three Information Processing Biases Defined and Illustrated 117

Overview of the Structure of Chapters 10 through 16 117

Chapter 10 Mental Accounting Bias 119

Bias Description 119

Practical Application 121

Research Review 123

Diagnostic Testing 128

Advice 130

The Behavioral Finance Approach to Asset Allocation based on Mental Accounting 133

Notes 134

Chapter 11 Anchoring and Adjustment Bias 135

Bias Description 135

Practical Application 136

Research Review 138

Diagnostic Testing 139

Advice 140

Bonus Discussion: Investment Strategies that Leverage Anchoring and Adjustment Bias 141

Notes 142

Chapter 12 Framing Bias 143

Bias Description 143

Practical Application 145

Research Review 148

Diagnostic Testing 150

Advice 152

Notes 153

Chapter 13 Availability Bias 155

Bias Description 155

Practical Application 157

Research Review 160

Diagnostic Test 162

Advice 163

Notes 164

Chapter 14 Self-Attribution Bias 165

Bias Description 165

Practical Application 166

Research Review 167

Diagnostic Testing 169

Advice 170

Notes 171

Chapter 15 Outcome Bias 173

Bias Description 173

Diagnostic 176

Notes 178

Chapter 16 Recency Bias 179

Bias Description 179

Practical Application 181

Research Review 184

Diagnostic Testing 185

Advice 187

Notes 188

Part Four Emotional Biases Defined and Illustrated 189

Chapter 17 Loss Aversion Bias 191

Bias Description 191

Practical Application 193

Research Review 194

Diagnostic Testing 195

Advice 196

Notes 197

Chapter 18 Overconfidence Bias 199

Bias Description 199

Practical Application 200

Research Review 201

Diagnostic Testing 203

Advice 206

A Final Word on Overconfidence 208

Notes 208

Chapter 19 Self-Control Bias 211

Bias Description 211

Practical Application 214

Research Review 216

Diagnostic Testing 219

Advice 220

Notes 222

Chapter 20 Status Quo Bias 223

Bias Description 223

Practical Application 224

Research Review 225

Diagnostic Testing 226

Advice 228

Notes 229

Chapter 21 Endowment Bias 231

Bias Description 231

Practical Application 232

Research Review 235

Diagnostic Testing 237

Advice 239

Notes 240

Chapter 22 Regret Aversion Bias 243

Bias Description 243

Practical Application 244

Research Review 246

Diagnostic Testing 247

Advice 249

Notes 251

Chapter 23 Affinity Bias 253

Bias Description 253

Research Review 256

Diagnostic Testing 258

Advice 259

Notes 260

Part Five Application of Behavioral Finance to Asset Allocation and Case Studies 261

Chapter 24 Application of Behavioral Finance to Asset Allocation 263

Practical Application of Behavioral Finance 264

Best Practical Allocation 266

Guidelines for Determining Best Practical Asset Allocation 267

Quantitative Guidelines for Incorporating Behavioral Finance in Asset Allocation 269

Investment Policy and Asset Allocation 271

Notes 271

Chapter 25 Case Studies 273

Case Study A: Mr. Nicholas 276

Case Study B: Mrs. Alexander 281

Summary of Case Studies 286

Part Six Behavioral Investor Types 287

Chapter 26 Behavioral Investor Type Diagnostic Process 289

Background of the Development of Behavioral Investor Types 290

Psychographic Models of Investor Behavior 291

Early Psychographic Models 293

The Behavioral Alpha Process: A Top-Down Approach 295

The BIT Identification Process 296

Summary 299

Notes 300

Chapter 27 Behavioral Investor Types 301

Introduction 301

Preserver 302

Follower 305

Independent 308

Accumulator 312

Summary 315

Index 317

MICHAEL M. POMPIAN, CFA, CFP, is a partner at Mercer Investment Consulting, a firm serving institutional and private wealth clients. Prior to joining Mercer, he was a wealth management advisor with Merrill Lynch and PNC Private Bank, and served on the investment staff of a family office. Pompian is a Chartered Financial Analyst (CFA), a Certified Financial Planner (CFP), and a Certified Trust Financial Advisor (CTFA). He is also a member of the CFA Institute (formerly AIMR) and the New York Society of Security Analysts (NYSSA). He holds a BS in management from the University of New Hampshire and an MBA in finance from Tulane University. Pompian is a regular speaker on the subject of behavioral finance and has published several articles on the subject. He is married with three sons and can be reached at michael.pompian@mercer.com.

Since the first edition of Behavioral Finance and Wealth Management was published—in the wake of the bursting of the technology bubble in 2000—the world faced yet another economic crisis in 2008. Accompanying this crisis is a new level of market volatility, and both investors and advisors can benefit from a deeper understanding of behavioral finance and how it can help them achieve their long-term financial goals. That’s why author Michael Pompian, a wealth manager and practitioner at the forefront of the practical application of behavioral finance, has written the second edition of this book.

As an investment advisor, Pompian understands the behavioral biases that investors have. He has discovered specific ways to adjust investment strategies for these biases and in the Second Edition of Behavioral Finance and Wealth Management, Pompian helps investors and their advisors develop a heightened awareness of these biases so that financial decisions, and resulting economic outcomes, can be improved.

Divided into six comprehensive parts, this reliable guide opens with an introduction to the basics of behavioral finance, focusing on the aspects most relevant to individual wealth management. From here, Parts Two (Belief Perseverance Biases), Three (Information Processing Biases), and Four (Emotional Biases) define and illustrate a total of twenty of the most important biases—within the cognitive-emotional framework—for considering potential biases. For each of the twenty biases, Pompian uses the same basic format in discussing the bias, in order to promote greater accessibility.

After covering the foundations of behavioral finance, the biases, Part Five turns to the main focus of this book: practical application of behavioral finance for investors and advisors. This section establishes a basic framework for integrating behavioral finance insights into portfolio structure and presents the concept of best practical allocation. It then takes the concepts presented and applies them in a case study format to reinforce learning.

Rounding out this detailed discussion, Part Six ties together many of the concepts covered in the book and introduces a new concept Pompian has developed to make behavioral finance easier to apply in practice. The idea of Behavioral Investor Types (BITs) is introduced along with the investment biases that are associated with each one.

Updated to reflect current market conditions, this reliable resource skillfully illustrates investors’ behavioral biases in detail and offers financial advisors and their clients practical advice about how to apply the science of behavioral finance to improve overall investment decision making.

Praise for the first edition of Behavioral Finance and Wealth Management

“Pompian is handing you the magic book, the one that reveals your behavioral flaws and shows you how to avoid them. The tricks to success are here. Read and do not stop until you are one of very few magicians.”
—Arnold S. Wood, President and Chief Executive Officer, Martingale Asset Management

“I wish this book had been available a decade ago; by understanding behavioral biases, clients and professionals can stay focused and comfortable throughout the markets’ bubbles and doldrums. Michael Pompian moves our profession forward by proposing a standardized structure for this approach.”
—Elizabeth K. Miller, CFA, Managing Director, Trevor Stewart Burton & Jacobsen Inc., and former chair, New York Society of Security Analysts’ Wealth Management Committee

“Many inefficiencies in the market are the result of how investors let their emotions dictate their investment decisions. Michael Pompian’s work provides a framework to understand why these inefficiencies exist, and how they can provide investors with significant profit-making opportunities.”
—Stanley G. Lee, CFA, Principal, David J. Greene & Company, LLC

“Michael Pompian has created a valuable resource for investors and those in the wealth management community by not only explaining a number of important behavioral biases, but also giving them actionable steps to reduce biases and improve investment performance.”
—John M. Longo, PhD, CFA, Senior Vice President, Investment Strategy, The MDE Group, Inc., and Adjunct Professor of Finance, Rutgers University Graduate School of Management