February 23, 2012

New Behavioral Finance Findings and Optimal Asset Allocation

Swiss academic suggests advisors use clients' reference points and mental accounting to build portfolios

That individual investors react more to their financial market losses than to their financial market gains is one of the more well-established behavioral finance theories put forth by Nobel Prize laureate Daniel Kahneman and Amos Tversky, and one that more and more financial advisors are taking into account these days as they seek to apply behavioral finance principles to their practices.

In order to fully comprehend the process behind loss aversion and the impact it has on an individual’s investment portfolios and investment goals, Enrico De Giorgi, professor in the School of Economics and Political Science at the University of St. Gallen in Switzerland and founding partner at Zurich-based firm Behavioural Finance Solutions, believes that financial advisors also need to take into account the fact that all individuals have different “reference points” for their losses and their gains. These subjective mental markers, he says in a recent paper, “A Behavioral Explanation of the Asset Allocation Puzzle,” are the points at which individuals determine where their losses end and their gains begin. Trying to figure them out can go a long way toward understanding loss aversion and coming up with the optimal asset allocation for an individual.

“People care about losses more than they care about gains, and so they penalize losses more than they reward gain,” De Giorgi says. “But where the utility of losses is overweighted compared to gains, the reference point is very important because people don’t only look at the payoff from a particular investment, they have a reference point in mind. They consider an investment a good one if they can fulfill the reference point in mind, and they consider it to be bad if they don’t fulfill the reference point.”

Each person’s reference point is subjective, and most people have multiple reference points. It’s also not obvious how people reach their individual reference points, but regardless, all individuals penalize themselves for not reaching their particular reference points much more than they reward themselves when they do actually reach them, De Giorgi says, because “while you may like reaching your reference point, you don’t like reaching it as much as you dislike not reaching it.”

Further to reference points, individual investors also have so-called “mental accounts,” which essentially is the means by which they “organize a complex problem like investing in their mind,” De Giorgi says. Mental accounting means, for example, “splitting up investments into different sub-problems according to specific investment goals,” which, again, is a subjective process, he says.

For important investment goals, investors tend to prefer conservative investment strategies, and they favor bonds over stocks, (the amount by which they do so would, of course, depend on the extent of their loss aversion), while for very ambitious goals, investors are willing to take more risk.

It is not important, De Giorgi says, for investors to be able to understand the ins and outs of every asset class. However, both advisors and investors do need to understand the links between peoples’ reference points or investment goals, their loss aversion and risk profiles, because this confluence is what determines why “for investor A it is optimal to choose asset allocation A and for investor B to choose asset allocation B,” De Giorgi says.

“An investor does not have to be very sophisticated, but he has to understand why, given his understanding of risk, his investment goals and attitude to risk, he gets a particular allocation and not another,” he says. Unfortunately “often it is not the risk attitude that generates the choice of once asset over another, it is misperception,” and this must be avoided.

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