Behavioral Finance and Wealth Management

MICHAEL M. POMPIAN, CFA, CFP, is a partner at Mercer Investment Consulting, a firm serving institutional and private wealth clients. Prior to joining Mercer, he was a wealth management advisor with Merrill Lynch and PNC Private Bank, and served on the investment staff of a family office. Pompian is a Chartered Financial Analyst (CFA), a Certified Financial Planner (CFP), and a Certified Trust Financial Advisor (CTFA). He is also a member of the CFA Institute (formerly AIMR) and the New York Society of Security Analysts (NYSSA). He holds a BS in management from the University of New Hampshire and an MBA in finance from Tulane University. Pompian is a regular speaker on the subject of behavioral finance and has published several articles on the subject. He is married with three sons and can be reached at michael.pompian@mercer.com.

• Preface xvAcknowledgments xxiiiPart One Introduction to Behavioral Finance 1Chapter 1 What Is Behavioral Finance? 3Behavioral Finance: The Big Picture 4Standard Finance versus Behavioral Finance 12The Role of Behavioral Finance with Private Clients 19How Practical Application of Behavioral Finance Can Create a Successful Advisory Relationship 19Notes 21Chapter 2 The History of Behavioral Finance Micro 23Historical Perspective on the Link between Psychology and Economics 23Modern Behavioral Finance 27Psychographic Models Used in Behavioral Finance 36Notes 40Chapter 3 Introduction to Behavioral Biases 43Introduction 43Behavioral Biases Defined 44Why Understanding and Identifying Behavioral Biases Is Important 45Categorization of Behavioral Biases 46Differences between Cognitive and Emotional Biases 46Difference among Cognitive Biases 47Emotional Biases 48A Final Word on Biases 49Summary of Part One 50Part Two Belief Perseverance Biases Defined and Illustrated 51Chapter 4 Cognitive Dissonance Bias 53Bias Description 53Practical Application 55Research Review 57Diagnostic Testing 59Advice 60Conclusion 62Notes 62Chapter 5 Conservatism Bias 63Bias Description 63Practical Application 64Research Review 67Diagnostic Testing 69Advice 70Notes 71Chapter 6 Confirmation Bias 73Bias Description 73Practical Application 75Research Review 77Diagnostic Testing 81Advice 83Notes 84Chapter 7 Representativeness Bias 85Bias Description 85Practical Application 87Research Review 89Diagnostic Testing 93Advice 94Notes 97Chapter 8 Illusion of Control Bias 99Bias Description 99Practical Application 100Research Review 103Diagnostic Testing 104Advice 105Final Thought 106Notes 106Chapter 9 Hindsight Bias 107Bias Description 107Practical Application 108Research Review 109Diagnostic Testing 112Advice 113Notes 114Part Three Information Processing Biases Defined and Illustrated 117Overview of the Structure of Chapters 10 through 16 117Chapter 10 Mental Accounting Bias 119Bias Description 119Practical Application 121Research Review 123Diagnostic Testing 128Advice 130The Behavioral Finance Approach to Asset Allocation based on Mental Accounting 133Notes 134Chapter 11 Anchoring and Adjustment Bias 135Bias Description 135Practical Application 136Research Review 138Diagnostic Testing 139Advice 140Bonus Discussion: Investment Strategies that Leverage Anchoring and Adjustment Bias 141Notes 142Chapter 12 Framing Bias 143Bias Description 143Practical Application 145Research Review 148Diagnostic Testing 150Advice 152Notes 153Chapter 13 Availability Bias 155Bias Description 155Practical Application 157Research Review 160Diagnostic Test 162Advice 163Notes 164Chapter 14 Self-Attribution Bias 165Bias Description 165Practical Application 166Research Review 167Diagnostic Testing 169Advice 170Notes 171Chapter 15 Outcome Bias 173Bias Description 173Diagnostic 176Notes 178Chapter 16 Recency Bias 179Bias Description 179Practical Application 181Research Review 184Diagnostic Testing 185Advice 187Notes 188Part Four Emotional Biases Defined and Illustrated 189Chapter 17 Loss Aversion Bias 191Bias Description 191Practical Application 193Research Review 194Diagnostic Testing 195Advice 196Notes 197Chapter 18 Overconfidence Bias 199Bias Description 199Practical Application 200Research Review 201Diagnostic Testing 203Advice 206A Final Word on Overconfidence 208Notes 208Chapter 19 Self-Control Bias 211Bias Description 211Practical Application 214Research Review 216Diagnostic Testing 219Advice 220Notes 222Chapter 20 Status Quo Bias 223Bias Description 223Practical Application 224Research Review 225Diagnostic Testing 226Advice 228Notes 229Chapter 21 Endowment Bias 231Bias Description 231Practical Application 232Research Review 235Diagnostic Testing 237Advice 239Notes 240Chapter 22 Regret Aversion Bias 243Bias Description 243Practical Application 244Research Review 246Diagnostic Testing 247Advice 249Notes 251Chapter 23 Affinity Bias 253Bias Description 253Research Review 256Diagnostic Testing 258Advice 259Notes 260Part Five Application of Behavioral Finance to Asset Allocation and Case Studies 261Chapter 24 Application of Behavioral Finance to Asset Allocation 263Practical Application of Behavioral Finance 264Best Practical Allocation 266Guidelines for Determining Best Practical Asset Allocation 267Quantitative Guidelines for Incorporating Behavioral Finance in Asset Allocation 269Investment Policy and Asset Allocation 271Notes 271Chapter 25 Case Studies 273Case Study A: Mr. Nicholas 276Case Study B: Mrs. Alexander 281Summary of Case Studies 286Part Six Behavioral Investor Types 287Chapter 26 Behavioral Investor Type Diagnostic Process 289Background of the Development of Behavioral Investor Types 290Psychographic Models of Investor Behavior 291Early Psychographic Models 293The Behavioral Alpha Process: A Top-Down Approach 295The BIT Identification Process 296Summary 299Notes 300Chapter 27 Behavioral Investor Types 301Introduction 301Preserver 302Follower 305Independent 308Accumulator 312Summary 315Index 317