Author: www.wealthplanning.co.za

Article by Mohamed Ismail and Kgothatso Nyabela – Article from BusinessDay 

Behavioural finance is clear about investor biases and the resultant suboptimal financial outcomes. At least three methods help mitigate behavioural biases when investing: education, investment process and goal-based investing.

Lack of education is a cognitive bias that, unlike emotional biases, is easy to mitigate by making investors more self-aware. By understanding how to control for behavioural influences, and the degree of control investors have over cognitive and emotional responses, investment advisers work with clients to achieve rational investment outcomes.

A formal investment process mitigates behavioural influences. This practice has to be objectively designed before investment decisions are made that may be influenced by behavioural biases. A sound process is structured to eliminate or reduce the potential effect of biases.

An investment process is recommended to identify objectives; optimise a portfolio to fund specific investment outcomes considering long-term capital market expectations; fulfil the asset allocation with passive, smart beta or systematic solutions (selectively active) while considering expenses and tax efficiency; and stay the course as prescribed in the investment process.

Risk preference

Goal-based investing has quickly become a new paradigm in modern portfolio management. It mitigates behavioural biases while also producing an optimal asset allocation that funds lifetime aspirations. It primarily exploits the mental accounting bias to produce a dynamic asset allocation customised according to a threshold target and risk preference.

By framing the investment problem around risk preference to drive portfolio selection, goal-based investing mitigates the loss-aversion bias. Changing the focus from short-term return ambitions to a framework based on accomplishing investment outcomes, goal-based investing provides a construct for more informed decision-making and leads to more rational investing and outcomes.

Mental accounting theory becomes an outcome-based portfolio problem. It combines traditional portfolio theory from Markowitz and the behavioural portfolio theory of Shefrin and Statman.

The mean-variance theory is a production theory in that investors produce a range of portfolios based on a combination of expected returns and risk (measured through variance or standard deviation) and select what is best for them. The portfolios they select are said to be efficient. Mean-variance investors thus face a production function in the mean-variance space and choose to consume from the set of efficient portfolios produced that maximise their utility — that is seek a portfolio that fulfils a need or want.

Many sub-portfolios

Investors require that their portfolios satisfy outcomes over the investment horizon so they have enough money to retire on, fund their children’s education or grow sufficient wealth to satisfy a spending need.

Investors have different attitudes to risk for different requirements. This is precisely the mental accounting theory behind investor behaviour. Investors do not consider their portfolios as a whole. Instead, their total portfolio is composed of many subportfolios or mental accounts. Each subportfolio is associated with a goal or target. Each of these goals is selected based on a probability of achieving that goal.

Traditionally, the notion of risk is associated with the standard deviation of investment return. However, investors do not understand this definition of risk well. Framing the definition of risk differently should ideally dispel ambiguity between the investor and adviser, and determine the preference for taking risk more clearly. Investors typically will associate risk with the likelihood of not achieving their aspirations. In terms of risk as defined by the standard deviation of the portfolio return, decreasing risk in an underfunded portfolio only increases the likelihood of not achieving the desired outcome.

The behavioural portfolio theory of Shefrin and Statman suggests that investors care about the expected return of each subportfolio, but instead of measuring risk using the standard deviation of expected returns they use the probability of failing to reach the threshold level of their mental account as the measure of risk.

Each account faces the efficient frontier or set of mean-variance optimal portfolios and by trading off between expected return and the probability of failing to reach a threshold level associated with their goal, an optimal portfolio is selected.

The benefits of the mental accounting framework are that objectives and risk preferences are framed differently and resonate better with investors in terms of what is expected from portfolios. This also does away with measuring portfolio performance against standardised benchmarks, as the objective is clear — the goal is the benchmark.

Goal-based investing is undoubtedly a paradigm shift for investors in modern portfolio management. It paves the way for democratising the investment process through transparency and promotes an understanding of individual preferences and long-term ambitions between investor and investment adviser.

The goal-based investing framework mitigates behavioural biases while producing an optimal asset allocation that funds lifetime aspirations. The probability of reaching or failing to reach an investment target is integral and should be considered as the modern standard for risk measurement in behavioural portfolios.

What does this mean for contemporary portfolio management? There is a basis for refining the portfolio-choice problem initially designed for rational investors. By recognising that behavioural biases play a significant role in determining investment outcomes, goal-based investing provides a framework for investors to express behavioural elements through an intuitive language of probability.

Ismail and Nyabela are fund managers with Ashburton Investments.

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