In one part of CFAI curriculum ( I think in “Individuals”) is mentioned that asset management favors an individual’s goals as short and long term objectives in different layers while in other parts such individual’s reasoning is considered as Mental accounting bias. Pretty confusing.
When you inherit 1m you will treat it differently than if you earn 1m. So say you now have 2m but in your mind you treat the 1m inherited as having less weight in your portfolio. Therefore you tend to invest/spend this money more easily than your hard earned cash. You will invest your earned cash in low risk investments because you can’t afford to lose this money, while the other 1m can be invested in more risky investments because you have less emotional attachment to it even if you lose it. Translated in time horizon, your hard earned cash will be invested in a long term goal while the inheritance in more short term less strategic goals.
Yes, I understand but if I differ cash earned by my salary and cash earned by lottery, it is mental accounting bias because cash equals cash anyway if I would loose it, there is no difference. In one kind of PM approach, individuals are encouraged to build different layers and invest according to long term or short term targets. In some other places of curriculum, this is also considered as some kind of “deviant” behavior or mental accounting. Thus, where is the border between normal portfolio investing in various layers according investor’s objectives and frenzied mental accounting bias?
This is what I understood
mental accounting ===> asset segregation
for example an individual will save bonus and consume his salary or vice versa. The money does not have the same allocation based on its provenance!
asset segregation ====> different risk buckets or portfolio layers
For example the individual then chooses to put funds from bonus in more risky assets (equity) and saving from salary in less riskier assets ( govt. bonds)
an Asset manager must think first about the long term objective of the client (a client outliving his asset is bad) but must take into account biases of the client otherwise the client may not stick with the established portfolio (short term market fluctuation) not letting the portfolio’s strategy to work
I hope that I understood your question and I answered it 
Thanks Javad. Yes you understood. What I think it is individual manager’s approach to different clients. If manager’s assumes that particular client suffers by accounting bias, layer approach might not be as good for that client because it will feed his/her bias. For another client (f.ex. with gambler character) layer approach might be good solution.
So by studying behavioral finance are we trying to educate investors to act rationally or on the contrary, recognize that investors are less than rational and their portfolios sometimes will justifiably be sub-optimal? In other words feeding investor biases is not such a bad thing.
I don’t know but it’s funny. As Harrogath said, all those biases should be recognized against deviation from mean-variance portfolio. If there is no deviation, such bias, if any, would not be an issue. PM are not psychiatrists, thus biases are just recognized as the barriers in building efficient portfolio.
There is only one issue here Kroko
we do not try to transform the client into an R.E.M. But to make stick with a portfolio that satisfy his O&C and us
thus it is not the optimal portfolio and the less standard of living risk the more you can accommodate your client biases
Yeah.
Also something interesting is that Behavioral Finance does not look for efficient portfolios, but the most comfortable portfolio an investor could handle taking account its behavioral biases. Human beings are not machines, and it is much, much likely an investor is willing to lose some money (from not holding an optimum portoflio), than sticking to an optimum portfolio and battle against its fears, hates and emotions in order to hold such portfolio in the long term.
However, some investors can be educated to take risks and to overcome some cognitive biases (the most likely to overcome, because emotional biases are hard to beat), that’s a job for the PM (presumably).
Very good point Horragath.
In the case of mental accounting, I believe, is just a bias that the investor will live with, and the portfolio manager may try accommodate in his O&C’s.
I would like to add an inquiry on this topic if thats okay, it has been bugging me. If a client suffers from the mental accounting bias and allocates assets using the pyramid/layering approach without taking asset class correlations into consideration. Then as a PM is not it our job to structure the “pyramid” taking correlation into consideration. We can always present the asset allocation to the client in layers without explaining the correlation component .
Or am I incorrectly linking strategic asset allocation and the layering approach?
“GBI is consistent with the concept of loss-aversion in prospect theory. The client can see that more important goals are exposed to less risky assets and less potential loss. It is better suited to wealth preservation than to wealth accumulation. By utilizing the mental accounting of layers to meet goals, the client can better understand the construction of the portfolio.”
That’s taken directly from Schweser. I don’t see any problem with presenting an investment portfolio in layers to the client so they understand it better. However during the construction process I’d consider correlation, right?
We may conclude that is strongly depended on client’s behavior. What is strongly recommended for risk seeking investors is not the most appropriate strategy for the cowards and vice versa.
i believe you are right googs1484. the idea here is that, yes, client is allowed to fall in the temptation to use mental accounting to layer/split his portfolio. But, you, as a portfolio manager,don’t want your client to contemplate a suboptimal aggregate investment. That is how you take into consideration correlations in GBI.
Furthermore, another thing that i have been contemplating is how BMAA, GBI and BPT interact with our ethical requirements pertaining to Duties to clients, Suitability. For example, a client with high relative wealth and low SLR, whom suffers from emotional biases. The curriculum states to “accommodate” these biases in this situation. As a PM we have the most leeway in deviations from the optimal portfolio. They can take on a lot of risks but would if the client insists on holding a suboptimal portfolio with the same expected return as the optimal but much higher risks not incorporating correlation or simply have an endowment bias with a specific position. Do we accommodate this or do we potentially have an ethical obligation to end our relationship with this client?
What’s ethics got to do with this? Yo have a clearly documented IPS and a happy client.
Just because it’s documented in the IPS doesn’t make it right. In level III I’m learning more than ever that everything in someway interacts with every other reading. It all ties together.