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Preface

If successful, this book will change your idea about what an optimal portfolio is. It is intended to be a guide to both understanding irrational investor behavior and creating portfolios for individual investors that account for these irrational behaviors. In this book, an optimal portfolio lies on the efficient frontier, but may move up or down it depending upon the individual needs and preferences of you as an individual investment decision-maker. When applying behavior finance to real-world investment portfolios, an optimal portfolio is one that an investor can comfortably live with, so that he or she has the ability to adhere to his or her investment program, while at the same time reach long-term financial goals.

Given the run-up in stock prices from 2009, in the wake of the global financial crisis, to 2020, and the bear market brought on by the novel coronavirus, understanding irrational investor behavior is as important as it has ever been. This is true both for the markets in general, but most especially for individual investors. The intended audience for the book is sophisticated individual investors who wish to become more introspective about their own behaviors, and to truly try to understand how to create a portfolio that works for them. The intention is that it is a guidebook, to be used and implemented in the pursuit of building better portfolios. When considering behavioral finance, investors rightly have questions. Some of these are:

 What are the most common investor biases that cause investment mistakes?

 What are the most impactful biases?

 How do I create the best allocation for me, taking into consideration my behavioral tendencies?

 How do I stick to a long-term investment plan?

 Should I buy individual stocks or stick to a diversified portfolio?

This book will answer these questions. There is difference between this book and my prior books. Most of my prior work has been written through the lens of how financial advisors advise: That is, how financial advisors can work better with their clients. This book, however, is written from the point of view of the investor. The only part of the book that has the financial advisor perspective is the case studies at the end. This is intentional. I want you, the investor, to pretend you are an advisor. This way you can implement the lessons in the book, which will drive home the learning.

In the last 25 years, the interest in behavioral finance as a discipline has not simply emerged, but rather exploded onto the scene, with many articles written by very prestigious authors in prestigious publications. We will review some of the key people who have shaped the current body of behavioral finance thinking, and review work done by them. And then the intent is to take the study of behavioral finance to another level: Developing a common understanding (definition) of behavioral biases in terms that advisors and investors can understand, and then demonstrate how they are to be used in practice through the use of case studies—a “how-to” of behavioral finance. We will also explore some of the new frontiers of behavioral finance, things not even discussed now that may be common knowledge in 25 years.

A Challenging Environment

Investors have never had more challenging times to invest in. Many investors thought they had found nirvana in the late 1990s, only to find themselves in quicksand in 2001 and 2002. And then we had the bull market of the 2000s only to get taken down by the 2008–2009 Great Recession. Today, we have had the longest bull market in history interrupted by the novel coronavirus bear market. In today's environment, as well as in the past, investors are continuously asking themselves:

 “Is asset allocation important or should I concentrate my investments?”

 “Should I invest in alternative investments?”

 “Should I have any bonds?”

 “Should I take the same approach to investing in college money as retirement money?”

 “Should I hold cash or stay fully invested?”

 “How should I modify my portfolio allocation based on my behavioral biases?”

To that end, investors need a handbook like this one that can help them deal with the behavioral and emotional side of investing, so that they can help themselves understand why they have trouble sticking to a long-term program of investing. By implementing the lessons in the book, you too can reach financial goals.

Why This Book?

When I began taking an interest in how portfolios might be adjusted for behavioral biases back in the late 1990s, when the technology bubble was in full force, I sought a book like this one, but couldn't find one. I did not set a goal of writing a book at that time, I merely took an interest in the subject, and began reading. It wasn't until my wife, who was going through a job transition and came home one night talking about the Myers-Briggs personality type test she had taken, did I begin to consider the idea of writing about behavioral finance. My thought process at the time was relatively simple: Doesn't it make sense that people of differing personality types would want to invest differently? I couldn't find any literature on this topic. Fast-forward to today and this is my fifth book, and one that brings together a “greatest hits” of my work.

As a wealth manager myself, I have found the value of understanding the behavioral biases that investors have and discovered some ways to adjust investment programs for these biases. You will learn about these methods. By writing this book, I hope to spread the knowledge that I have developed and accumulated, so that other advisors and investors can benefit from these insights. Up until now, there has not been a book available that has served as a guide for the advisor or sophisticated investor to create portfolios that account for biased investor behavior. My fervent hope is that this book changes that.

Who Should Use This Book?

For individual investors who have the ability to look introspectively and assess their behavioral biases, this book is ideal. Many individual investors who choose either to “do it yourself” or rely on a financial advisor only for peripheral advice, often find themselves unable to separate their emotions from the investment decision making process. This does not have to be a permanent condition. By reading this book and delving deep into your behaviors, individual investors can indeed learn to modify behaviors and create portfolios that help them to stick to their long-term investment programs, and thus reach their long-term financial goals. Financial Advisors can also greatly benefit from the book.

When to Use This Book

First and foremost, this book is generally intended for investors who want to apply behavioral finance to the asset allocation process and create better portfolios for themselves. Some suggestions for when to take it off the shelf are:

 There is an opportunity to create or re-create an asset allocation from scratch. Having a large amount of cash can be a tricky thing for any investor. When should I put the money to work? At the same time, the lack of “baggage,” such as emotional ties to certain investments, tax implications, and a host of other issues that accompany an existing allocation, is ideal. The time to apply the principles learned in this book is at the moment that one has the opportunity to invest only cash or “clean house” on an existing portfolio.

 A life “trauma” has taken place. Sometimes investors are faced with a critical investment decision during a traumatic time, such as a divorce, a death in the family, a job loss, or other similar life event. These are the times that this book can add a significant amount of value to this type of situation by using its concepts.

 A concentrated stock position is held. When an investor holds a single stock or other concentrated stock position, emotions typically run high. In my practice, I find it incredibly difficult to get people “off the dime” to diversify their holdings in a single stock. The reasons are well known: “I know the company, so I feel comfortable holding the stock”; “I feel disloyal selling the stock”; “My peers will look down on me if I sell any stock”; “My grandfather owned this stock, so I will not sell it”; the list goes on and on. This is the exact time to employ behavioral finance. Advisors must isolate what biases are being employed by the investor, and then work together with the investor to relieve the stress caused by these biases. This book is essential in these cases.

 Retirement. When an investor enters the retirement phase, behavioral finance becomes critically important. This is so because the portfolio structure can mean the difference between living a comfortable retirement and outliving one's assets. Retirement is typically a time of reassessment, reevaluation, and is a great opportunity for the advisor to strengthen and deepen the relationship to include behavioral finance.

 Wealth Transfer and Legacy is being considered. Many wealthy investors want to leave a legacy. Is there any more emotional issue than this one? Having a frank discussion about what is possible and what is not, is difficult and often fraught with emotional cross-currents that the advisor would be well advised to stand clear of. However, by bringing behavioral finance into the discussion and setting an objective outside the councilor's viewpoint, the investor may well be able to draw his or her own conclusion about what direction to take when leaving a legacy.

 Trust Creation. Creating a trust is also a time of emotion, that may bring psychological biases to the surface. Mental accounting comes to mind. If an investor says to him or herself “OK, I will have this pot of trust money over here to invest, and that pot of spending money over there to invest” the investor may well miss the big picture of overall portfolio management. The practical application of behavioral finance can be of great assistance at these times.

Naturally, there are many more situations not listed here that can arise where this book will be helpful.

Plan of the Book

The first part of the book is an introduction to the practical application of behavioral finance. These chapters will include an overview of what behavioral finance is at an individual investor level and an introduction to the behavioral biases that will be used when incorporating investor behavior into the asset allocation process. Parts Two, Three, and Four include a comprehensive review, complete with a general description, practical application, implications for investors, a bias diagnostic, and advice. Part Five of the book reviews four Behavioral Investor Types, or BITS, and pulls everything together in the form of case studies that will clearly demonstrate how investors can use behavioral finance in real-world portfolio settings. Part Six covers portfolio implementation: Behavioral Finance Aspects of the Active/Passive Debate, Behaviorally Aware Portfolio Construction, and Behavioral Finance and Market Corrections.