Behavioral Finance and Wealth ManagementHow to Build Investment Strategies That Account for Investor Biases
Wiley Finance, Band 667 2. Aufl.
The book that applies behavioral finance to the real world Understanding how to use behavioral finance theory in investing is a hot topic these days. Nobel laureate Daniel Kahneman has described financial advising as a prescriptive activity whose main objective should be to guide investors to make decisions that serve their best interests. The reality? That's easier said than done. In the Second Edition of Behavioral Finance and Wealth Management, Michael Pompian takes a practical approach to the growing science of behavioral finance, and puts it to use for real investors. He applies knowledge of 20 of the most prominent individual investor biases into "behaviorally-modified" asset allocation decisions. Offering investors and financial advisors a "self-help" book, Pompian shows how to create investment strategies that leverage the latest cutting edge research into behavioral biases of individual investors. This book: Shows investors and financial advisors how to either moderate or adapt to behavioral biases, in order to improve investment results and identifies "the best practical allocation" for investment portfolios. Using these two sound approaches for guiding investment decision-making, behavioral biases are incorporated into the portfolio management process Uses updated cases studies to show investors and financial advisors how an investor's behavior can be modified to improve investment decision-making Provides useable methods for creating behaviorally modified investment portfolios, which may help investors to reach their long term financial goals Heightens awareness of biases so that financial decisions and resulting economic outcomes are improved Offers advice on managing the effects of each bias in order to improve investment results This Second Edition illustrates investors' behavioral biases in detail and offers financial advisors and their clients practical advice about how to apply the science of behavioral finance to improve overall investment decision making.
Preface xv Acknowledgments xxiii PART ONE Introduction to Behavioral Finance 1 CHAPTER 1 What Is Behavioral Finance? 3 Behavioral Finance: The Big Picture 4 Standard Finance versus Behavioral Finance 12 The Role of Behavioral Finance with Private Clients 19 How Practical Application of Behavioral Finance Can Create a Successful Advisory Relationship 19 Notes 21 CHAPTER 2 The History of Behavioral Finance Micro 23 Historical Perspective on the Link between Psychology and Economics 23 Modern Behavioral Finance 27 Psychographic Models Used in Behavioral Finance 36 Notes 40 CHAPTER 3 Introduction to Behavioral Biases 43 Introduction 43 Behavioral Biases Defined 44 Why Understanding and Identifying Behavioral Biases Is Important 45 Categorization of Behavioral Biases 46 Differences between Cognitive and Emotional Biases 46 Difference among Cognitive Biases 47 Emotional Biases 48 A Final Word on Biases 49 Summary of Part One 50 PART TWO Belief Perseverance Biases Defined and Illustrated 51 CHAPTER 4 Cognitive Dissonance Bias 53 Bias Description 53 Practical Application 55 Research Review 57 Diagnostic Testing 59 Advice 60 Conclusion 62 Notes 62 CHAPTER 5 Conservatism Bias 63 Bias Description 63 Practical Application 64 Research Review 67 Diagnostic Testing 69 Advice 70 Notes 71 CHAPTER 6 Confirmation Bias 73 Bias Description 73 Practical Application 75 Research Review 77 Diagnostic Testing 81 Advice 83 Notes 84 CHAPTER 7 Representativeness Bias 85 Bias Description 85 Practical Application 87 Research Review 89 Diagnostic Testing 93 Advice 94 Notes 97 CHAPTER 8 Illusion of Control Bias 99 Bias Description 99 Practical Application 100 Research Review 103 Diagnostic Testing 104 Advice 105 Final Thought 106 Notes 106 CHAPTER 9 Hindsight Bias 107 Bias Description 107 Practical Application 108 Research Review 109 Diagnostic Testing 112 Advice 113 Notes 114 PART THREE Information Processing Biases Defined and Illustrated 117 Overview of the Structure of Chapters 10 through 16 117 CHAPTER 10 Mental Accounting Bias 119 Bias Description 119 Practical Application 121 Research Review 123 Diagnostic Testing 128 Advice 130 The Behavioral Finance Approach to Asset Allocation based on Mental Accounting 133 Notes 134 CHAPTER 11 Anchoring and Adjustment Bias 135 Bias Description 135 Practical Application 136 Research Review 138 Diagnostic Testing 139 Advice 140 Bonus Discussion: Investment Strategies that Leverage Anchoring and Adjustment Bias 141 Notes 142 CHAPTER 12 Framing Bias 143 Bias Description 143 Practical Application 145 Research Review 148 Diagnostic Testing 150 Advice 152 Notes 153 CHAPTER 13 Availability Bias 155 Bias Description 155 Practical Application 157 Research Review 160 Diagnostic Test 162 Advice 163 Notes 164 CHAPTER 14 Self-Attribution Bias 165 Bias Description 165 Practical Application 166 Research Review 167 Diagnostic Testing 169 Advice 170 Notes 171 CHAPTER 15 Outcome Bias 173 Bias Description 173 Diagnostic 176 Notes 178 CHAPTER 16 Recency Bias 179 Bias Description 179 Practical Application 181 Research Review 184 Diagnostic Testing 185 Advice 187 Notes 188 PART FOUR Emotional Biases Defined and Illustrated 189 CHAPTER 17 Loss Aversion Bias 191 Bias Description 191 Practical Application 193 Research Review 194 Diagnostic Testing 195 Advice 196 Notes 197 CHAPTER 18 Overconfidence Bias 199 Bias Description 199 Practical Application 200 Research Review 201 Diagnostic Testing 203 Advice 206 A Final Word on Overconfidence 208 Notes 208 CHAPTER 19 Self-Control Bias 211 Bias Description 211 Practical Application 214 Research Review 216 Diagnostic Testing 219 Advice 220 Notes 222 CHAPTER 20 Status Quo Bias 223 Bias Description 223 Practical Application 224 Research Review 225 Diagnostic Testing 226 Advice 228 Notes 229 CHAPTER 21 Endowment Bias 231 Bias Description 231 Practical Application 232 Research Review 235 Diagnostic Testing 237 Advice 239 Notes 240 CHAPTER 22 Regret Aversion Bias 243 Bias Description 243 Practical Application 244 Research Review 246 Diagnostic Testing 247 Advice 249 Notes 251 CHAPTER 23 Affinity Bias 253 Bias Description 253 Research Review 256 Diagnostic Testing 258 Advice 259 Notes 260 PART FIVE Application of Behavioral Finance to Asset Allocation and Case Studies 261 CHAPTER 24 Application of Behavioral Finance to Asset Allocation 263 Practical Application of Behavioral Finance 264 Best Practical Allocation 266 Guidelines for Determining Best Practical Asset Allocation 267 Quantitative Guidelines for Incorporating Behavioral Finance in Asset Allocation 269 Investment Policy and Asset Allocation 271 Notes 271 CHAPTER 25 Case Studies 273 Case Study A: Mr. Nicholas 276 Case Study B: Mrs. Alexander 281 Summary of Case Studies 286 PART SIX Behavioral Investor Types 287 CHAPTER 26 Behavioral Investor Type Diagnostic Process 289 Background of the Development of Behavioral Investor Types 290 Psychographic Models of Investor Behavior 291 Early Psychographic Models 293 The Behavioral Alpha Process: A Top-Down Approach 295 The BIT Identification Process 296 Summary 299 Notes 300 CHAPTER 27 Behavioral Investor Types 301 Introduction 301 Preserver 302 Follower 305 Independent 308 Accumulator 312 Summary 315 Index 317
Michael M. Pompian, CFA, CFP, is a partner at Mercer Investment Consulting, a firm serving institutional and private wealth clients. Prior to joining Mercer, he was a wealth management advisor with Merrill Lynch and PNC Private Bank, and served on the investment staff of a family office. Pompian is a Chartered Financial Analyst (CFA), a Certified Financial Planner (CFP), and a Certified Trust Financial Advisor (CTFA). He is also a member of the CFA Institute (formerly AIMR) and the New York Society of Security Analysts (NYSSA). He holds a BS in management from the University of New Hampshire and an MBA in finance from Tulane University. Pompian is a regular speaker on the subject of behavioral finance and has published several articles on the subject. He is married with three sons and can be reached at email@example.com.
Behavioral Finance and Wealth Management How to Build Investment Strategies That Account for Investor Biases Since the first edition of Behavioral Finance and Wealth Management was published—in the wake of the bursting of the technology bubble in 2000—the world faced yet another economic crisis in 2008. Accompanying this crisis is a new level of market volatility, and both investors and advisors can benefit from a deeper understanding of behavioral finance and how it can help them achieve their long-term financial goals. That's why author Michael Pompian, a wealth manager and practitioner at the forefront of the practical application of behavioral finance, has written the second edition of this book. As an investment advisor, Pompian understands the behavioral biases that investors have. He has discovered specific ways to adjust investment strategies for these biases and in the Second Edition of Behavioral Finance and Wealth Management, Pompian helps investors and their advisors develop a heightened awareness of these biases so that financial decisions, and resulting economic outcomes, can be improved. Divided into six comprehensive parts, this reliable guide opens with an introduction to the basics of behavioral finance, focusing on the aspects most relevant to individual wealth management. From here, Parts Two (Belief Perseverance Biases), Three (Information Processing Biases), and Four (Emotional Biases) define and illustrate a total of twenty of the most important biases—within the cognitive-emotional framework—for considering potential biases. For each of the twenty biases, Pompian uses the same basic format in discussing the bias, in order to promote greater accessibility. After covering the foundations of behavioral finance, the biases, Part Five turns to the main focus of this book: practical application of behavioral finance for investors and advisors. This section establishes a basic framework for integrating behavioral finance insights into portfolio structure and presents the concept of best practical allocation. It then takes the concepts presented and applies them in a case study format to reinforce learning. Rounding out this detailed discussion, Part Six ties together many of the concepts covered in the book and introduces a new concept Pompian has developed to make behavioral finance easier to apply in practice. The idea of Behavioral Investor Types (BITs) is introduced along with the investment biases that are associated with each one. Updated to reflect current market conditions, this reliable resource skillfully illustrates investors' behavioral biases in detail and offers financial advisors and their clients practical advice about how to apply the science of behavioral finance to improve overall investment decision making.
Praise for the first edition of Behavioral Finance and Wealth Management "Pompian is handing you the magic book, the one that reveals your behavioral flaws and shows you how to avoid them. The tricks to success are here. Read and do not stop until you are one of very few magicians." —Arnold S. Wood, President and Chief Executive Officer, Martingale Asset Management "I wish this book had been available a decade ago; by understanding behavioral biases, clients and professionals can stay focused and comfortable throughout the markets' bubbles and doldrums. Michael Pompian moves our profession forward by proposing a standardized structure for this approach." —Elizabeth K. Miller, CFA, Managing Director, Trevor Stewart Burton & Jacobsen Inc., and former chair, New York Society of Security Analysts' Wealth Management Committee "Many inefficiencies in the market are the result of how investors let their emotions dictate their investment decisions. Michael Pompian's work provides a framework to understand why these inefficiencies exist, and how they can provide investors with significant profit-making opportunities." —Stanley G. Lee, CFA, Principal, David J. Greene & Company, LLC "Michael Pompian has created a valuable resource for investors and those in the wealth management community by not only explaining a number of important behavioral biases, but also giving them actionable steps to reduce biases and improve investment performance." —John M. Longo, PhD, CFA, Senior Vice President, Investment Strategy, The MDE Group, Inc., and Adjunct Professor of Finance, Rutgers University Graduate School of Management
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