MICHAEL M. POMPIAN
Copyright © 2021 by Michael M. Pompian. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data
Names: Pompian, Michael M., 1963- author.
Title: Behavioral finance and your portfolio : a navigation guide for building wealth / Michael M. Pompian.
Description: Hoboken, New Jersey : Wiley, [2021] | Includes index.
Identifiers: LCCN 2021008937 (print) | LCCN 2021008938 (ebook) | ISBN 9781119801610 (hardback) | ISBN 9781119802006 (adobe pdf) | ISBN 9781119801993 (epub)
Subjects: LCSH: Finance—Psychological aspects. | Investments—Psychological aspects. | Investments—Decision making.
Classification: LCC HG101 .P658 2021 (print) | LCC HG101 (ebook) | DDC 332.601/9—dc23
LC record available at https://lccn.loc.gov/2021008937
LC ebook record available at https://lccn.loc.gov/2021008938
Cover Design: Wiley
Cover Image: © sorbetto/DigitalVision Vectors/Getty Images
Founded in 2016, Sunpointe Investments is a wealth management firm that also creates books and articles. Sunpointe is committed to developing first class research and investing content for individuals and financial advisors. Content topics range from portfolio management to behavioral finance and much more.
For a list of article and books, please visit our Web site at www.sunpointeinvestments.com.
This book is dedicated to my three sons Nicholas, Alexander, and Spencer.
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:
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.
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:
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.
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.
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.
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:
Naturally, there are many more situations not listed here that can arise where this book will be helpful.
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.
I would like to acknowledge all my colleagues and clients who have contributed to broadening my knowledge in behavioral finance and wealth management.
Michael M. Pompian, CFA, CFP, CAIA, is the Founder and Chief Investment Officer of Sunpointe Investments, a multi-family office investment firm in St. Louis, Missouri. He was formerly a Partner at Mercer Investment Consulting for 10 years and was the National Segment Leader for the private wealth business where he consulted to the firm's largest family office clients, overseeing $8 billion. Prior to joining Mercer, Michael was a Wealth Management Advisor with Merrill Lynch and a private banker with PNC Private Bank. Prior to these positions, Michael was on the investment staff of a family office. Michael earned his MBA in Finance from Tulane University and graduated from the University of New Hampshire with a BS degree in Management. Michael has written four books: Advising Ultra-Affluent Clients and Family Offices (Wiley 2009), Behavioral Finance and Wealth Management (Wiley 2006), Behavioral Finance and Wealth Management, 2nd Edition (Wiley 2012) and Behavioral Investor Types (Wiley 2015). He writes a monthly column for Morningstar Advisor and has been quoted in Money Magazine, The New York Times, Bloomberg, and CNBC, among other media outlets. Michael holds the Chartered Financial Analyst (CFA) designation, Chartered Alternative Investment Analyst (CAIA), Certified Financial Planner (CFP®), and Certified Trust Financial Advisor (CTFA). He is a member of the CFA Institute, the New York Society of Securities Analysts (NYSSA), and the CFA Society of St. Louis. He is a regular speaker at family office conferences globally.
In Chapters 1 and 2, Part One of the book, readers will get an introduction to behavioral finance. This will set up Chapters 3 through 22, which review 20 behavioral biases, both cognitive and emotional. Two types of cognitive bias are reviewed in Chapters 3 through 15: Belief Perseverance cognitive biases are covered in Chapters 3 through 8, and Information Processing cognitive biases are covered in Chapters 9 through 15. Emotional biases are then covered in Chapters 16 through 22. After these chapters, the book introduces four Behavioral Investor Types (BITs) and then the BITs are applied in four case studies.