Is the primary detraction from this style of portfolio construction that it ignores the correlation between various layers and therefore doesn’t appropriately reflect/capture risk? Any other reason why pyramiding is not considered rational and causes a portfolio to be suboptimal?
Also, how does an advisor actually incorporate behavioral biases in the IPS and actually adjust a portfolio for them - how does this make the portfolio better approach a traditional optimal portfolio? The text mentions these things but provides no specifics regarding how certain adjustments or steps are actually executed.
you seem to be an inquisitive person, very useful for possible practical application
however, you’re not doing yourself a favor by distracting yourself with unnecessary questions such as yours however smart the questions are, just remember the behavioral finance concepts as described and you wil be fine in this section of the exams
Mental accounting influences asset location policy through focusing on individual goals (children education, living expenses, etc.) from a more rational/optimal look at the portfolio as a whole. As te example of “pyramiding”, the investor is focusing on investments w/ very low risk (guaranteed) while he can actually reach higher returns at the same level of risk through diversification to possibly reach all goals quicker.
IPS includes return, risk and constrains for a certain client, not an investor. The behavior underlined are concerned with investors, not clients. i.e., the person in managing the fund/investment.
the reading just mentioned, ignoring correlation so dont worry about some other reason as you won’t be asked about that in the exam
the objective of considering behavioral biases is not to make behaviorally modified portfolio better than traditional portfolio but rather to make the behaviorally modified portfolio approximates the outcome of the traditional portfolio as the latter is optimal. This point is 2nd of the two options prescribed in the readings — moderate the impact of the bias so portfolio is closer to optimal
The first of the two options mentioned to develop the modified portfolio (i.e. accounting for the bias) is to adapt to the bias so that manager is left with altering the ‘should be’ optimal asset allocation of the traditional finance portfolio. The readings prescribe the degree of deviations from the rational/optimal asset allocation depending on the bias type (cognitive or emotional).
i don’t agree with your last sentence. Behavioral biases are those of the client, not the adviser. It’s the adviser’s job to recognize them, and work out whether to adjust the portfolio or try to educate the client so they think differently. (Obviously advisers can have biases too, but that’s not the focus of the CFA readings.)
to the original question: Also, how does an advisor actually incorporate behavioral biases in the IPS and actually adjust a portfolio for them - how does this make the portfolio better approach a traditional optimal portfolio? Adjusting the portfolio will take it away from being “optimal” in a traditional finance sense. BUT is more likely to be something the client is happy with and will continue to hold even when times are tough. There’s no point having an optimal portfolio if your client freaks out and sells it when markets fall. If an adviser just keeps trying to force something on a client that they’re not happy with, they’ll get fired. (even if a fancy model says it’s the optimal portfolio for a client to hold.)
So the purpose of adjusting the IPS is to get something that’s as close as possible to an optimal portfolio, while also being something that the client can live with.