Behavioural Finance and Wealth Management

Michael Pompian takes the angle of applying Behavioural Finance to individual financial advice in his book, 'Behavioural Finance and Wealth Management'.

I have just finished the first part which provides and introduction to Behavioural Finance, the history of Behavioural Finance Micro, and his structure for incorporating investor behaviour into the asset allocation process.

He says...

'An optimal portfolio is one with which an investor can comfortably live, so that he or she has the ability to adhere to his or her investment program, while at the same time reach long-term financial goals'

`a client's best practical allocation may be a slightly underperforming long-term investment program to which the client can adhere, warding off the impulse to "change horses" in the middle of the race"

'the right allocation is the one that helps the client to attain financial goals while simultaneously providing psychological security for the client to sleep at night.'

'Instead of a universal theory of investor behaviour, behavioural finance research relies on a broad collection of evidence pointing to the ineffectiveness of human decision making in various economic decision-making circumstances.'

The next 22  chapters which I have just started go through a variety of biases in an attempt to provide practical advice on how to mitigate them.

My gut response is that it is a worthwhile attempt, and though I know I should delay judgement, I think he may be caught in the middle. The structure he proposes is still based on adjusting what a rational investor under traditional finance with portfolio optimisation should do, allowing for biases.

I have a deep distrust of using volatility as a measure of risk. That provides the basis of Portfolio Optimisation, where there is a tradeoff between volatility and return in the belief that to get higher returns, you need to accept higher volatility.

So... and I will delay judgement (as much as I can), I continue reading more in the hope of improving my understanding of the different biases rather than having any confidence in his methodology of providing a solution.

A useful distinction he makes is between cognitive biases, and emotional biases. Cognitive biases are easier to remedy since they can be `reasoned' with. Emotional biases are delving into a world where portfolio managers, advisers, accountants, actuaries and the like have far less claim to fame.

Daniel Kahneman, winner of the the Nobel Prize for Economics in 2002 for his work in Behavioural Finances is a psychologist rather than an economist.

The benefits of working across fields.