Incorporating Behavioral Finance into Your Practice

Pompian, Michael M.; Longo, John M.
March 2005
Journal of Financial Planning;Mar2005, Vol. 18 Issue 3, p58
Academic Journal
Irrational investor behavior is commonly observed by wealth management practitioners when creating and administering investment solutions for their private clients. Many advisors would like to address behavioral issues, but lack diagnostic tools and application guidelines to employ behavioral finance research with clients. Many clients would be well served by adjusting their asset allocations to account for biased behavior. By doing so, they would stand a better chance of adhering to their investment programs and enjoy better long-term investment results. In applying behavioral finance research to client situations, practitioners must decide whether to attempt to change their clients' biased behavior or adapt to it. Furthermore, quantitative guidelines need to be available when modifying asset allocations to account for biased behavior. Practitioners should adapt to biases at high wealth levels and attempt to modify behavior at lower wealth levels. They should adapt to emotional biases and moderate cognitive biases. These actions will lead to a client's best practical allocation. Three case studies illustrate how these guidelines are applied. A quantitative model is also unveiled that calculates acceptable discretionary distances from the mean-variance output for determining the best practical allocation. The article offers practitioners a framework to better understand how behavioral finance can be applied to their individual clients. INSET: Executive Summary.


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