Did anyone else find it kind of obnoxious that the behavioral finance study session said that individuals try to pyramid their portfolio and engage in mental accounting and asset segmentation because they’re irrational humans who don’t understand mean-variance analysis, and then two study sessions later they describe how life insurance companies engage in asset segmentation because it makes so much sense to match assets to liabilities?
Life insurance companies have a regulatory obligation to necessarily meet their liabilities and hence need to engage in ALM. Individual Investors might not have any such mandatory obligations and thus may be engaging in pyramiding only due to their behavorial bias.
jpallav Wrote: ------------------------------------------------------- > Life insurance companies have a regulatory > obligation to necessarily meet their liabilities > and hence need to engage in ALM. Individual > Investors might not have any such mandatory > obligations and thus may be engaging in pyramiding > only due to their behavorial bias. Yes I agree. But what about the goals-based investing approach?
jpallav Wrote: ------------------------------------------------------- > Life insurance companies have a regulatory > obligation to necessarily meet their liabilities > and hence need to engage in ALM. Individual > Investors might not have any such mandatory > obligations and thus may be engaging in pyramiding > only due to their behavorial bias. There is a difference between Behavioral PREFERENCES and Behavioral BIASES. We need to be careful here. Biases are bad because they distort true picture and introduce errors in decision making. As an Investment Advisor, we need to ACCOMODATE behavioral Preferences, whereas we need to CONTROL Behavioral Biases. Goal-based investing is a Preference and NOT a Bias and needs to be Accomodated. EDIT: Per Behavioral Finance theorists, Goal-based investing is coming from the Behavioral aspect of ‘Mental Accounting’ and it needs to be accomodated in IPS and in Strategic Asset Allocation process.
Behavioral theorists have argued that mental accounting, and the multiple goals on which it is based, is incompatible with traditional investment theory. Traditional theory suggests that an allocation should be established for an investor’s total portfolio. Risk is also managed at the total portfolio level, using an estimate for the investor’s overall risk tolerance. It is difficult to reconcile this single portfolio framework with separate mental accounts linked to multiple goals. An alternative to the traditional investment approach is to allow more than one strategy, as discussed by Shefrin and Statman [2000] and Brunel [2003]. Each strategy is linked to a goal and managed according to the risk measures and risk tolerance that are most appropriate for that goal. This approach, which we call goals-based investing, is compatible with mental accounting. Another advantage is that it manages the risk of not achieving goals rather than relying on traditional risk measures. (Level III Volume 2 Behavioral Finance, Individual Investors, and Institutional Investors , 4th Edition. Pearson Learning Solutions p. 295). It seems Mental Accounting is not very bad.
Is mental accounting / pryamiding bad??
june2009 Wrote: ------------------------------------------------------- > Is mental accounting / pryamiding bad?? No, it is not bad. It is a behavioural aspect of client and it is NOT one of the biases. Biases can be bad and they need to be controlled, but this aspect needs to be accomodated in IPS and while formulating Asset Allocation Strategy.