Chapter 3

Incorporating Investor Behavior

Into the Asset Allocation Process
Prepared By : DR. Wael Shams EL-Din
Practical Application of BF
❑ The researches suggests that Behavioral finance is a growing field and
is ideally founded to assist the real-world economic actors. However,
many of biases have been identified but NOT used by Financial
advisors in the Normal Wealth Management.
Why does Behavioral Finance Remain NOT used by Financial
advisors in the Normal Wealth Management ?
❑ Academic researchers have worked hard to discover behavioral biases,
however practitioners would NOT get any benefit out of these
academic researches as long as provide useful guidelines in real life.
❑ The Practitioners needs to understand how to identify such biases and
how to advise their clients to avoid such biases in order to achieve best
result.
❑ Once an investor’s behavioral biases have been identified, advisors
want a realistic guidelines for tailoring the asset allocation process to
reflect the identified bias.
Asset Allocation Process
1. Provide investor with Risk tolerance questionnaires
2. Explain best practical Asset allocation
3. Identifies clients’ behavioral biases
4. Discusses how such biases would change asset allocation decision
5. Reviews a quantitative guideline methodology

Explain Best Discusses

Questionnaires Identifies
Practice in Impact of such Quantitative
for Risk Clients’
Asset Biases in Guideline
Tolerance Biases
Allocation Allocation
Risk Tolerance Questionnaires
❑ For compliance reasons , Financial service firms require their advisors to
perform and record risk tolerance questionnaires to clients and potential
clients prior to drafting any asset allocation.
❑ In the absence of any other diagnostic analysis, this methodology is
certainly useful and generates important information about the investor,
However, it is important to recognize the limitations of risk tolerance
questionnaires.

❑ From the behavioral Finance perspective, risk Tolerance questionnaires may

work well for institutional investors but fail regarding psychologically biased
individuals.
Limitations of Risk Tolerance
Questionnaires
❑ Risk tolerance questionnaires don’t have a significant Impact on portfolio
design.
❑ Risk tolerance questionnaire can generate dramatically different results when
repeated frequently but in different formats to the same individual.
❑ Wrong imprecisions may arises from using variations in the wording of
questions.
❑ Most of risk tolerance questionnaires are introduced to investor once, and
may NOT be presented again while risk tolerance of investor can be change
as a result of events throughout life.
❑ Advisors may interpret the results wrongly. For example, some clients might
indicate that the maximum loss they would be willing to tolerate in a single
year would comprise 20% of their total assets . Does that mean that an ideal
portfolio would place clients in a position to lose 20%? The answer is No!
The Advisor should set portfolio parameters that prevent client from
incurring the maximum specified acceptable loss in any given period.
Identify Behavioral Biases with Investor
❑ Through our course we will discuss different type of biases (cognitive
and emotional), along with strategies for identifying and applying them
in investor relationships.

❑ In real life, biases are diagnosed by means of a specific series of

questions. Therefore identifying biases will improve the quality of
advice to investor , when taking into account behavioral factors.
How to apply Bias diagnoses when
Structuring Asset Allocations
❑ when considering behavioral biases in asset allocation, financial advisors
must first determine whether to moderate or to adapt to “irrational”
client preferences.
❑ The principles laid out in this section offer guidelines for resolving the
puzzle “When to moderate, when to adapt?”
❑ In applying behavioral finance , practitioners must decide whether to
attempt to change their clients’ biased behavior or adapt to it.
❑ Practitioners should adapt to biases at high wealth levels and attempt to
modify behavior at lower wealth levels.
❑ They should adapt to emotional biases and moderate cognitive biases.
These actions will lead to a client’s best practical allocation
Incorporating Investor Behavior
into the Asset Allocation Process

Accommodate Accommodate

Educate
Educate if Possible
Thank You