The Art Of Asset Allocation and Associated Biases

Traditional finance presumed that investors are rational, meaning they are risk-averse, self-serving utility-maximisers who process available information with no biases involved. Consequently, investors have the ability to develop and hold portfolios that maximise their satisfaction and returns.

The fact that psychological influences can work against investors in making good investing decisions is ignored by the traditional theory.

Behavioural finance, on the other hand, asserts that people’s psychological and cognitive biases play a key role in different financial phenomena. It attempts to explain how investors perceive events, develop tendencies that reflect in their investment decisions, which may or may not be the best. And rightly so, real life experience seems to support the behaviourists.

Good Read- Understanding Behavioural Finance & Investment Decisions

Amos Tversky, Daniel Kahneman, and Richard Thaler are all known as the fathers of behavioural finance.

Deep Dive Into Behavioural Finance

Understanding Behavioural Finance can facilitate investors and fund managers in avoiding emotion-driven speculation, which could otherwise cause losses, and develop realistic and appropriate wealth management strategies.

Although successful investing principles are available to nearly everyone for buying and selling financial assets, sometimes there could be a disconnect between knowledge and behaviour when it comes to saving and investing.

For instance, when it comes to retirement planning, which is an important financial goal as longevity increases around the world, it is recommended that people start as early as possible to build up maximum funds in the active years of working so as to spend those golden years comfortably post retirement. While people realise, they should be doing so, a very few actually act on it.

Behavioural Issues Vs Asset Allocation

Now let’s look at some of the behavioural issues that impact an investor’s approach to Asset Allocation, which is the strategy of dividing one’s investments across different class of assets inlcuding stocks, bonds, mutual funds, real estate, cash, and cash alternatives. It is one of the most crucial decisions for an investor regarding long?term investment returns and determines how many assets and what percentage of each would be included in a client’s portfolio.

The right asset allocation for a client would depend upon how well the allocation’s characteristics and behaviour match the client’s objectives and constraints, which are typically captured in the investor’s Investment Policy Statement (IPS).

Interesting Read: What does Fear Do to your Portfolio? Stocks that Scared Investors in 2019

The primary objective of asset allocation is to mitigate risk through diversification of investment portfolio and maximise returns. Below are some of the behavioural issues that influence/impact asset allocation:

• Contrast Bias: It is a natural tendency of a human mind to mentally upgrade or downgrade an object, basis its comparison to another object. For example, you would feel better upon comparing your BMW to a Maruti than a Maserati. In investing, this distorts the perception of an asset class for an individual.
• Recency Bias: It refers to the phenomenon of a person remembering something that has happened recently more vividly than remembering something that may have occurred a while back. As a result, such investors tend to overweight this most recent information. For example, If an investor heard of a company doing really well in the present or not doing well, he/she may value only that information, ignoring everything else that happened before.
• Base Rate Fallacy: When a person, due to cognitive reasons, gives too little weight to the base, or original rate, of possibility (i.e., the probability of A given B), then it is called a base rate fallacy or

base rate neglect. In behavioural finance, this is indicative of investors’ tendency to erroneously predict the likelihood of an outcome by not incorporating all the relevant data. Here, the investors tend to focus heavily on new information without acknowledging the impact of original assumptions.

• Gambler’s Fallacy: This fallacy, also known as the Monte Carlo fallacy, refers to the misconception that a certain event, which has not happened for a long period of time, would happen for sure or if a certain event has occurred more frequently than normal during the past, it is not likely to happen in the near future. In reality, the probability of such events does not relay on what has happened in the past and is statistically independent. To understand, some investors may liquidate a stance when, say the price of a stock goes up after a long series of trading sessions with the belief that it would now tread downward.
• Anchoring: In scenarios where an investor gets fixated on a particular fragment of information while staying oblivious to other information available that could be equally important and relevant to the decision-making process, it is known as anchoring. For example, an investor may focus on the value of a previous portfolio so much so that he/she constantly compares it to the current value. Another way to understand this bias is from the case of buying a used car when the buyer may only focus on the odometer reading that also considering the fact how meticulously maintained the engine and transmission have been.
• Herding: When an investor imitates the actions and investment decisions of other investors, it is due to the herd mentality phenomenon. It more common to an individual than fund managers. The notion of herding in financial markets relates to the event where agents choose to act on similar lines as their peers, independently of their private information.
• Window Dressing: Considered as an unfair and fraudulent practice, window dressing is used by companies or even financial managers to tamper with the financial statements and reports for the sake of demonstrating a more favourable performance for a period of time. It is dishonest and is done to mislead the investors.
• Aversion to Risk: It is said that the pain of a big loss lasts much longer than the euphoria that comes from a huge win, implying that losses are twice as impactful as gains. Same is the case in the world of investing, loss aversion explains an investor’s predisposition to not venture out and invest in high-risk assets while maintaining traditional stance. But it should also be noted that sometimes high-risk investments avenues are directly associated with high returns in case of success of that investment.

Having said that, experienced wealth management practitioners find the task of administering investment solutions to private clients exhaustive with the need to apply both a keen awareness of “less than rational” decision-making and a potential interest in the branch of economics, i.e., behavioural finance that gives some sneak peek into the irrational investor behaviour. While fund managers and advisors are willing to incorporate these factors, there is not widely accepted “industry standard” methodology of identifying an individual investor’s biases. Although, the academic research on behavioural finance is quite fascinating, and growing robust and influential with each passing day, there is a need for quantitative guidelines to account for biased behaviour while modifying asset allocations.