Behavioral Finance and Financial Planning
The concept of behavioral finance is closely related to financial planning. Behavioral finance has recently become a subject of significant interest to investors. Because it is a relatively new and developing concept in economics and consequently not properly defined. We can describe the concept of Behavioral Finance in so many ways. The following are few of them
1) Behavioral finance is the integration of classical economics and finance with psychology and the decision-making sciences.
2) Behavioral finance is an attempt to explain what causes some of the anomalies that have been observed and reported in the finance literature.
3) Behavioral finance is the study of how investors systematically make errors in Judgment, or "mental mistakes."
Behavioral portfolio theory recognizes that people's needs are really a collection of aspirations. And people build portfolios, either consciously, or unconsciously, in layered terms, according to these aspirations." One layer is safe money, perhaps targeted for college education. Another layer is play money, money you are willing to gamble with hoping to make large profits by way of speculation and gambling.
This field of study argues that people are not nearly as rational as traditional finance theory makes out. For investors who are curious about how emotions and biases drive share prices, behavioral finance offers some interesting descriptions and explanations.
Investors have financial needs as well as psychological needs and their portfolios have to satisfy both. On the purely financial front, they need to save enough money to send their children to college or prepare for a non-problematic and secure retirement. Psychologically, they may also want their portfolio to match or outperform those of their peers -- or their goals may be less specific and not even fully conscious. Financial planners may have trouble meeting, or even identifying these different sets of needs. Behavioral finance offers ways to integrate both: the result is portfolios that are optimized according to financial theory -- and investor psychology.
"Behavioral finance can be extremely useful for wealth management. A good relationship between a planner and a client is more than managing money; it is also about managing the client's psychological needs associated with their portfolio. Behavioral finance is focused on predictable mistakes we all make when it comes to money and numbers too. Much of these mistakes have to do with faulty perception when it comes to calculations. For example, if we ask a question to anyone "if it takes 5 machines 5 minutes to make 5 pens, how long would it take 100 machines to make 100 pens?" most people would say 100. This is the natural answer. However, this is the wrong answer. Five minutes is the correct answer, just not the obvious one: it takes 1 machine 5 minutes to take 1 pen, 5 machines 5 minutes to make 5 pens, and similarly it takes 100 machines also 5 minutes to make 100 pens. Behavioral finance has used this sort of experiment, and applied it financial decisions, to map out the perception and also psychological mistakes we are all prone to when it comes to investing.
Overall, the behavioral approach analyzes how humans actually think about money, rather than how economists argue they should. Understanding clients' impulses and thoughts when it comes to wealth can be immensely helpful to both the advisor and the client
A planner can communicate they understand this wish, and also warn clients of some of the risks. So called lottery stocks, which have a very small probability of a very huge payoff, tend on average to do worse than the overall stock market. Tech stocks during the tech bubble are one example: some people struck it rich but over the long run most found their portfolios were decimated. Rather than fighting client's urges in this area,, "Maybe you want a little of the portfolio in 'play money' but recognize it as that."
Design the Behavioral Finance Portfolio
Despite the few years' history of behavioral finance, few investigators have suggested concrete ways to implement the learning of that branch of economics. Traditionally, in trying to get a sense of a client's tolerance for investment risk, financial advisors have engaged in rule of- thumb exercises or even more bizarre techniques. There was, for example, the approach we might call your-age is- your-fate: subtract your age from 100 and that's what your equity exposure should be. There were the predesigned portfolios assigned to clients according to their age range: if you were between 30 and 40, you got Portfolio A; between 40 and 50, Portfolio B, etc. My personal favorites were the bizarre questionnaires investors were asked to complete, however, two more promising approaches have been suggested:
• Statman has suggested that an investment portfolio be viewed as a pyramid, with the lowest-risk goals (and associated investments) at the broad bottom and the highest-risk goals (and associated investments) at the narrow top
• Brunel has elaborated on Statman's suggestion by converting Statman's pyramid into a more traditional portfolio design framework: Brunel invites the investor to quantify the relative importance of the four traditional investment goals: liquidity, income, capital preservation, and growth. "Behavior Finance" suggests a portfolio that might result from the use of the Statman/Brunel approach portfolio, reflecting behavioral finance's findings about loss aversion. Since three of the four investment goals (liquidity, income, capital preservation) tend to lead inevitably toward cautious strategies, and only one goal (growth) tends to lead toward more aggressive strategies, the behavioral finance portfolio has the likely disadvantage of growing too slowly to preserve the family's wealth over the years. But it has the advantage of being "comfortable" for the family, and representing a strategy the family is likely to stick with at least until they realize that their asset base hasn't kept pace with their expectations. In other words, our behavioral finance portfolio has indulged the family's inherent biases, but it may have resulted in a suboptimal portfolio that elevates comfort over investment
The behavioralists have yet to come up with a logical model that actually predicts the future rather than merely explains, with the benefit of intuition, what the market did in the past. The big lesson is that theory doesn't tell people how to beat the market. Instead, it tells us that psychology causes market prices and fundamental values to deviate for a long time.
Behavioral finance offers no investment miracles, but perhaps it can help investors train themselves how to be watchful of their behavior and, in turn, avoid mistakes that will decrease their personal wealth.
Behavioral finance offers no investment miracles, but perhaps it can help investors train themselves how to be watchful of their behavior and, in turn, avoid mistakes that will decrease their personal wealth.
Best Regards
Prakash Nair
www.keralites.net          |
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