00_POMPIAN_i_xviii 2/7/06 1:58 PM Page iii Behavioral Finance and Wealth Management How to Build Optimal Portfolios That Account for Investor Biases MICHAEL M. POMPIAN John Wiley & Sons, Inc. 00_POMPIAN_i_xviii 2/7/06 1:58 PM Page vi 00_POMPIAN_i_xviii 2/7/06 1:58 PM Page i Behavioral Finance and Wealth Management 00_POMPIAN_i_xviii 2/7/06 1:58 PM Page ii Founded in 1807, John Wiley & Sons is the oldest independent publish- ing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our cus- tomers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for fi- nance and investment professionals as well as sophisticated individual in- vestors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more. For a list of available titles, please visit our web site at www.Wiley Finance.com. 00_POMPIAN_i_xviii 2/7/06 1:58 PM Page iii Behavioral Finance and Wealth Management How to Build Optimal Portfolios That Account for Investor Biases MICHAEL M. POMPIAN John Wiley & Sons, Inc. 00_POMPIAN_i_xviii 2/7/06 1:58 PM Page iv Copyright © 2006 by Michael M. Pompian. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. 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Series HG4515.15.P66 2006 332.601'9—dc22 2005027756 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 00_POMPIAN_i_xviii 2/7/06 1:58 PM Page v This book is dedicated to my wife, Angela. I couldn’t have done this without her. 00_POMPIAN_i_xviii 2/7/06 1:58 PM Page vi 00_POMPIAN_i_xviii 2/7/06 1:58 PM Page vii Contents Preface ix Acknowledgments xvii PART ONE Introduction to the Practical Application of Behavioral Finance CHAPTER 1 What Is Behavioral Finance? 3 CHAPTER 2 The History of Behavioral Finance Micro 19 CHAPTER 3 Incorporating Investor Behavior into the Asset Allocation Process 39 PART TWO Investor Biases Defined and Illustrated CHAPTER 4 Overconfidence Bias 51 CHAPTER 5 Representativeness Bias 62 CHAPTER 6 Anchoring and Adjustment Bias 75 CHAPTER 7 Cognitive Dissonance Bias 83 CHAPTER 8 Availability Bias 94 CHAPTER 9 Self-Attribution Bias 104 CHAPTER 10 Illusion of Control Bias 111 CHAPTER 11 Conservatism Bias 119 CHAPTER 12 Ambiguity Aversion Bias 129 CHAPTER 13 Endowment Bias 139 CHAPTER 14 Self-Control Bias 150 CHAPTER 15 Optimism Bias 163 vii 00_POMPIAN_i_xviii 2/7/06 1:58 PM Page viii viii CONTENTS CHAPTER 16 Mental Accounting Bias 171 CHAPTER 17 Confirmation Bias 187 CHAPTER 18 Hindsight Bias 199 CHAPTER 19 Loss Aversion Bias 208 CHAPTER 20 Recency Bias 216 CHAPTER 21 Regret Aversion Bias 227 CHAPTER 22 Framing Bias 237 CHAPTER 23 Status Quo Bias 248 PART THREE Case Studies CHAPTER 24 Case Studies 257 PART FOUR Special Topics in Practical Application of Behavioral Finance CHAPTER 25 Gender, Personality Type, and Investor Behavior 271 CHAPTER 26 Investor Personality Types 282 CHAPTER 27 Neuroeconomics: The Next Frontier for Explaining Investor Behavior 295 Notes 303 Index 311 About the Author 318 00_POMPIAN_i_xviii 2/7/06 1:58 PM Page ix Preface f successful, this book will change your idea about what an optimal in- Ivestment portfolio is. It is intended to be a guide both to understanding irrational investor behavior and to creating individual investors’ portfolios that account for these irrational behaviors. In this book, an optimal port- folio lies on the efficient frontier, but it may move up or down that frontier depending on the individual needs and preferences of each investor. When applying behavior finance to real-world investment programs, 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. Given the run-up in stock prices in the late 1990s and the subsequent popping of the technology bubble, understanding irrational investor be- havior is as important as it has ever been. This is true not only for the markets in general but most especially for individual investors. This book will be used primarily by financial advisors, but it can also be effectively used by sophisticated individual investors who wish to become more in- trospective about their own behaviors and to truly try to understand how to create a portfolio that works for them. The book is not intended to sit on the polished mahogany bookcases of successful advisors as a show- piece: It is a guidebook to be used and implemented in the pursuit of building better portfolios. The reality of today’s advisor-investor relationship demands a better understanding of individual investors’ behavioral biases and an aware- ness of these biases when structuring investment portfolios. Advisors need to focus more acutely on why their clients make the decisions they do and whether behaviors need to be modified or adapted to. If advisors can successfully accomplish this difficult task, the relationship will be strengthened considerably, and advisors can enjoy the loyalty of clients who end the search for a new advisor. ix 00_POMPIAN_i_xviii 2/7/06 1:58 PM Page x x PREFACE In the past 250 years, many schools of economic and social thought have been developed, some of which have come and gone, while others are still very relevant today. We will explore some of these ideas to give some perspective on where behavioral finance is today. In the past 25 years, the interest in behavioral finance as a discipline has not only emerged but rather exploded onto the scene, with many articles written by very prestigious authors in prestigious publications. We will review some of the key people who have shaped the current body of behavioral finance thinking and review work done by them. And then the intent is to take the study of behavioral finance to another level: developing a common understanding (definition) of behavioral biases in terms that advisors and investors can understand and demonstrating how biases are to be used in practice through the use of case studies—a “how-to” of be- havioral finance. We will also explore some of the new frontiers of be- havioral finance, things not even discussed by today’s advisors that may be common knowledge in 25 years. A CHALLENGING ENVIRONMENT Investment advisors have never had a more challenging environment to work in. Many advisors thought they had found nirvana in the late 1990s, only to find themselves in quicksand in 2001 and 2002. And in today’s low-return environment, advisors are continuously peppered with vexing questions from their clients: “Why is this fund not up as much as that fund?” “The market has not done well the past quarter—what should we do?” “Why is asset allocation so important?” “Why are we investing in alternative investments?” “Why aren’t we investing in alternative investments?” “Why don’t we take the same approach to investing in college money and retirement money?” “Why don’t we buy fewer stocks so we can get better returns?” Advisors need a handbook that can help them deal with the behav- ioral and emotional sides of investing so that they can help their clients understand why they have trouble sticking to a long-term program of investing.