Any ideas on what appears to be a conflict in the text:
Schwser Book 1 Page 189: “Behaviorally moddifying a portfolio simply means constructing it according to the investor’s behavioral risk and return preferences. The strategy portfolio is probably not efficient from a modern portfolio theory perspective, but the investor is comfortable with it and will, thus, be more likely to adhere to the strategy.”
Schweser Book 1 Page 199: “By incorporating behavioral biases into clients’ IPSs, clients’ portfolios will tend to be closer to the efficient frontier , and clients will be more trusting and satisfied and tend to stay on track with their long term strategic plans.”
I guess it means that by understading the clients behavioural biases, you can take steps to make it more efficient than it would be otherwise. Emotional ones are tolerated more than cognitive ones.
behavioral portfolio - is not diversified in the true MVO sense. It is adding individual assets pretty much in a mental accounting kind of way … so the correlations among the assets are not considered the way they are in a MVO optimization or mathematical model. No mathematical constraints / objectives are set. If you need X of this to meet Y need - take it… (kind of approach).
They would be different - depending on the biases the individuals exhibit … so they are not efficient “in the financial sense” but are in the “behavioral sense”.
Since they meet the needs of the investor, and you as advisor helped them achieve that - the client is trusting, satisfied and tends to stay on track.
They meet the risk / return needs of the individuals too - otherwise they would not be satisfied. So they would be closer to the Eff. Frontier too.
ok i get all that, but if you incorporate behavioral biases–even if the client is more happy or trusting–the portfolio is less efficient than if there were no behavioral biases.
But the phrses "By incorporating behavioral biases into clients’ IPSs, clients’ portfolios will tend to be closer to the efficient frontier" doesn’t make sens then.
it is closer to efficient frontier in terms of risk / return characteristics…
even without considering the correlations.
Efficient frontier is just a plot of return vs. risk, isn’t it?
it could have been more efficient in terms of considering the correlations, (become more efficient in that sense) - but that would have thrown the asset class weights out of whack - and the client would not then appreciate what is being done.
So essentially a tradeoff.