Welcome, Sandbox friends.
Today’s Daily discusses:
behaviorally modified portfolios
Let’s dig in.
Blake
Markets in review
EQUITIES: Russell 2000 +1.27% | Nasdaq 100 +0.88% | S&P 500 +0.58% | Dow +0.31%
FIXED INCOME: Barclays Agg Bond -0.18% | High Yield +0.22% | 2yr UST 3.495% | 10yr UST 4.005%
COMMODITIES: Brent Crude +5.22% to $65.86/barrel. Gold +1.59% to $4,130.1/oz.
BITCOIN: +2.51% to $110,037
US DOLLAR INDEX: +0.06% to 98.952
CBOE TOTAL PUT/CALL RATIO: 0.83
VIX: -6.99% to 17.30
Quote of the day
“Happily ever after is not a fairy tale. It’s a choice.”
- Fawn Weaver
Behaviorally modified portfolios
Behavioral finance (BF) attempts to understand and explain observed investor and market behaviors. This differs from traditional finance (TF), which is based on hypotheticals about how investors and markets should behave. Practice vs. theory.
From a TF perspective, investment practitioners are taught to build portfolios along the efficient frontier optimizing risk against return. An appropriate portfolio for an investor is constructed holistically by considering a person’s tolerance for risk, investment objectives, constraints, liquidity needs, and unique circumstances. This may involve a risk questionnaire, an investment policy statement, financial plan, and software designed to optimize a portfolio.
But, this approach to portfolio construction implicitly assumes that investors have all this information incorporated and behave rationally.
After roughly two decades in this business, I can tell you the real world doesn’t work this way. People at home don’t plan and invest in this manner.
So, it’s imperative to relax these TF assumptions. Real world considerations, our emotional biases, and the cognitive errors must all be incorporated into the plan.
Several methods exist to help.
The first step is education – recognizing that these human elements exist and to be self-aware. When making an investment decision, consider if one or more biases or errors have influenced that decision. Document and reflect on decisions that do not align with your plan, investment objectives, and risk parameters. Maintain a schedule for periodic check-ins and reviews.
Another solution is writing out a formal investment plan or process. The benefit of a sound investment process is that it‘s objectively designed long before any investment decisions are made, before the next correction or bear market hits, and before life hits its first or even second major roadblock. A good process is structured to reduce or eliminate the potential impact from human behavior. This includes identifying goals and investment objectives, running scenarios using long-term capital market assumptions, selecting an optimal allocation that meets risk and return parameters, creating tolerance bands for asset classes and individual positions, identifying time horizons, etc etc.
Goals-based investing is another approach that incorporates many of these human elements while also producing an optimal lifetime asset allocation based on a financial plan. It requires investors focus on the purpose of their assets, which is to efficiently fund various lifetime goals along different timelines. A person structures their portfolio in layers to meet specific goals. Allocation of funds to an investment in each layer depends on the importance of each goal to the investor, with essential needs and obligations identified first. Structuring the overall portfolio in this manner provides the investor with the ability to frame risk more clearly.
Ultimately, the purpose of behaviorally modified portfolios is to adjust the same principles of TF in such a way that investors can build an achievable plan and successfully stick with it.
This should produce results closer to the optimal outcomes of TF, while being easier for an investor to adhere to in real life.
Investors are prone to panic and abandon the plan at the worst possible moments. By modifying their approach, investors can adopt a framework designed for more informed decision-making, which leads to more rational investing and a higher probability of successfully meeting their long-term interests.
Source: CFA Institute
That’s all for today.
Blake
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Welcome to The Sandbox Daily, a daily curation of relevant research at the intersection of markets, economics, and lifestyle. We are committed to delivering high-quality and timely content to help investors make sense of capital markets.
Blake Millard is the Director of Investments at Sandbox Financial Partners, a Registered Investment Advisor. All opinions expressed here are solely his opinion and do not express or reflect the opinion of Sandbox Financial Partners. This Substack channel is for informational purposes only and should not be construed as investment advice. The information and opinions provided within should not be taken as specific advice on the merits of any investment decision by the reader. Investors should conduct their own due diligence regarding the prospects of any security discussed herein based on such investors’ own review of publicly available information. Clients of Sandbox Financial Partners may maintain positions in the markets, indexes, corporations, and/or securities discussed within The Sandbox Daily. Any projections, market outlooks, or estimates stated here are forward looking statements and are inherently unreliable; they are based upon certain assumptions and should not be construed to be indicative of the actual events that will occur.
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