Understanding Investor Behavior and Strategic Asset Allocation: A Behavioral Finance Approach

1. Psychological influences on investor decisions A behavioral finance approach to strategic asset allocation The CFA Society of Victoria Victoria, BC September 21st, 2010 Jean L.P. Brunel, C.F.A

2. Three main points … • The inadequacy of current approaches: • A different model: • A practical application:

3. The inadequacy of current tools … Current approaches involve heavy quantitative input based on highly qualitative data … We do not speak the same language … 2,000,000,000 Index Values (USD) x x Compound Growth of Assets x 1,000,000,000 E[r] x 906,591,154 836,568,109 645,925,289 515,550,842 s 400,000,000 Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Sep 1995 1995 1996 1996 1997 1997 1998 1998 1999 1999 2000 2000 2001 2001 2002 2002 2003 Time Returns Histogram Returns Histogram Number 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% Return

4. What is the problem? The process is driven by an apparent desire to fit each investor into the same set mold … • Highly quantitative results, based on rough answers • No focus on the way the individual views the problem • Jargon overload

5. What is missing? • A healthy and meaningful interaction • A solution based on: • What “I,” the investor, want … and • How “I” want it • In short, a solution: • With which I can associate • and with which I can live over time

6. An alternative model Imagine a completely different approach, one starting with the investor… • Describing investors goals: • think of a menu of dishes, … • not of a menu of ingredients • Prioritizing and dollar weighting them: • Constructing appropriate sub-portfolios: • To “defease” each goal • in a way that makes sense to the investor • Combining them in an overall portfolio:

7. Behavioral finance insights … Behavioral finance starts where standard finance fails to explain or predict individual behaviors or needs …

8. Three fundamental goals… HNW investors usually have three distinct generic goals that competes for their attention … • Personal: • Meet current and unanticipated needs • Maintain future flexibility • Dynastic: • How much should my children get? • What about generations beyond them? • Philanthropic: • Active or passive philanthropy • Philanthropy as a family value

9. The behavioral finance portfolio … This design, initially proposed by Meir Statman, illustrates the fact that we have different views of risk for different goals … Investment risk Dynastic Aggressive Strategies Dynastic Passive Philanthropy Philanthropic Balanced Growth Portfolio Changes in dynastic/life- style and active philanthropy Flexibility Balanced Portfolio Tax-efficient, conservative Portfolio. Risk taken Only to preserve long- term purchasing power Personal Lifestyle Shelter and food

10. Behavioral finance insights … Behavioral finance theory helps us understand how investors behave rather than tell how they should behave… • Disutility of losses vs. utility of gains: • Downside risk minimization

11. Behavioral finance insights … Behavioral finance theory helps us understand how investors behave rather than tell how they should behave… • Disutility of losses vs. utility of gains • Downside risk minimization • Limited framing and hindsight biases: • Reactive decision mode

12. Behavioral finance insights … Behavioral finance theory helps us understand how investors behave rather than tell how they should behave… • Disutility of losses vs. utility of gains • Downside risk minimization • Limited framing and hindsight biases • Reactive decision mode • Overconfidence and illusion of control: • Momentum style

13. Behavioral finance insights … Behavioral finance theory helps us understand how investors behave rather than tell how they should behave… • Disutility of losses vs. utility of gains • Downside risk minimization • Limited framing and hindsight biases • Reactive decision mode • Overconfidence and illusion of control • Momentum style • Regrets: • Changing horses in mid race

14. Behavioral finance insights … Behavioral finance theory helps us understand how investors behave rather than tell how they should behave… • Disutility of losses vs. utility of gains • Downside risk minimization • Limited framing and hindsight biases • Reactive decision mode • Overconfidence and illusion of control • Momentum style • Regrets • Changing horses in mid race • Asset class or strategy prejudice

15. Goal-based asset allocation … How do you pick you meal in a restaurant? From a menu of dishes or a menu of ingredients? • Identify goals with which we can associate: • Liquidity • Income • Capital preservation • Growth

16. Goal-based asset allocation … • Identify goals with which we can associate • Liquidity • Income • Capital preservation • Growth • Structure sub-portfolios for each goal: • Manage • Report

17. Goal-based asset allocation … • Identify goals with which we can associate • Liquidity • Income • Capital preservation • Growth • Structure sub-portfolios for each goal • Manage • Report • Consider the full picture as a fiduciary

18. Four goals and more… We need to remain flexible in designing these goals, as an investor might prefer others … • Operating businesses • Opportunistic investments or trades • Collectibles • Others

19. The process, in short … Describe the main goals of our investor Dollar weigh and prioritize these goals Optimize these portfolios across the whole Structure a sub-portfolio for each goal

20. An illustrative case study … • John and Debbie, early 50’s, 4 children • $1 million AT spending needs • Want to start generational transfers • $5 million minimal philanthropic goal • $50 million in assets, yet … • … fear not having enough …

21. An illustrative case study … Their current portfolio is poorly constructed with little alternative asset exposure and much too much cash… Current expected AT return: 7.4% Current expected AT volatility: 8.1%

22. An illustrative case study … The first step is to create the appropriate “bucket” exposures. • Liquidity: $1 million • AT spending needs for a year

23. An illustrative case study … • Liquidity: $1 million • AT spending needs • Income: $8.2 million • To defease $1 mil/year for 10 year, 2% CPI • Assumes a 5.5% after tax return

24. An illustrative case study … • Liquidity: $1 million • AT spending needs • Income: $8.2 million • To defease $1 mil/year for 10 year, 2% CPI • Capital preservation: $5.4 million • To defeasespending needs for years 11-20 • Assumes a 6.1% after tax return

25. An illustrative case study … • Liquidity: $1 million • AT spending needs • Income: $8.2 million • To defease $1 mil/year for 10 year, 2% CPI • Capital preservation: $5.4 million • To defeasespending needs for years 11-20 • Real assets: $4.9 million

26. An illustrative case study … • Liquidity: $1 million • AT spending needs • Income: $8.2 million • To defease $1 mil/year for 10 year, 2% CPI • Capital preservation: $5.4 million • To defeasespending needs for years 11-20 • Real assets: $4.9 million • Growth: $30.6 million

27. An illustrative case study … Note the size of the “growth” sub-portfolio… • The growth portfolio allows: • Compounding for the future • Early philanthropic giving • Early generational transfers

28. An illustrative case study … Note the size of the “growth” sub-portfolio… and the allocation can be viewed in dynamic terms … • The growth portfolio allows • Compounding for the future • Early philanthropic giving • Early generational transfers • Income and capital preservation can be • Allowed to “mature” • Topped up and rebalanced annually

29. Back to the case study … • Liquidity: $1 million • AT spending needs • Income: $8.2 million • To defease $1 mil/year for 10 year, 2% CPI • Capital preservation: $5.4 million • To defeasespending needs for years 11-20 • Growth: $30.6 million + $4.9 in real assets

30. An illustrative case study … Note that each sub-portfolio makes sense, relative to its own basic goal … Optimized Bucket Allocation

31. An illustrative case study … The newly allocated portfolio satisfies their individual goals more closely, and seems much more efficient in financial terms … Expected AT return: 8.3% (+0.9%) Expected AT volatility: 7.3% (-0.8%)

32. Different rebalancing risks … • Set once and allowed to mature… • Until needs change … • Or until cash has run out! • Risk = worries as horizon-end approaches • Reviewed each year • Various buckets are rebalanced • Until no need to keep thinking that way … • Risk = over-exposure to low risk assets

33. Combining all in one … This overall portfolio seems to make sense, particularly when one looks at return and risk expectations per sub-portfolio … • Each bucket • Reinforces validity of choice • Aggregate • Meets goals in an understandable manner

34. Introducing asset location … Note the scope for asset location flexibility and that the tax-exempt pocket comprises tax-inefficient strategies … Optimized Asset Location

35. Three unintended benefits … • More sensible tactical rebalancing • Each move makes sense within sub-portfolio • Bet size consistent with goal breakdown • Promotes better advisor-client dialog • Income needs in relation to assets • Funding of very large asset purchases • Well suited to the use of FLP’s: • FLP focused on goal, not asset class • Allocation variations across generations

36. The current environment … • Dealing unusual conditions • Managing decision risk is real • What if capital market theory had holes? • Varying the definition of buckets • Goals versus fears • Intermediate versus long term • Same issue: “relating to one’s portfolio” • Understanding the language • Dealing with unusual/abnormal events

37. In short … • Current approaches have tight limits • The issue is all about making sense • Making sense reduces stress • Less stress reduces decision risk • Coping in difficult times • Fundamentally required • Emotionally necessary

38. Psychological influences on investor decisions A behavioral finance approach to strategic asset allocation The CFA Society of Victoria Victoria, BC September 21st, 2010 Jean L.P. Brunel, C.F.A