The difference between successful people and really successful people is that really successful people say no to almost everything.

—Warren Buffett

Introduction

The Behavioral Finance Approach to Asset Allocation Based on Mental Accounting

Leveraging the power of mental accounting for the benefit of attaining financial goals can be powerful. Our biases aren't necessarily harmful! There are two main topics in this chapter. First, we are going to discuss how a behavioral finance or a “goals-based” approach to asset allocation can be helpful in order to keep financial goals in mind when creating a portfolio. I have found the following approach, outlined in Figure 31.1, and based on investors' tendency to put money in separate mental accounts, to be of tremendous value at times. Not every investor likes or needs this approach to investing but some really like it. The second will be my firm's approach to asset allocation that leverages mental accounting but in a different way which we will explore later in the chapter.

Generally, what investors should aspire to do is focus on their needs and obligations, and make sure that they have enough of their portfolio carved out in capital preservation assets to meet those needs and obligations. Next, if desired, more risk can be taken to attain one's priorities and expectations, and, going further, even more risk can be taken to meet one's desires and aspirations. At the end of the process, investors usually end up with a diversified portfolio, though it will likely differ from a portfolio based on traditional mean-variance framework. However, the components of the portfolio are individually justified, based on needs and obligations versus priorities and expectations versus desires and aspirations.

Goals-Based Investing

Having specific goals for specific “buckets” of money leverages the positive aspects of mental accounting. Goals-based planning emphasizes the use of investment portfolios that allow you to reach your goals, rather than targeting a specific rate of return. Because each goal has a different return requirement and risk profile, you would in theory use different types of investments to reach each goal. Some investors are taking this approach but may not realize they are using a mental accounting or behavioral finance approach. For example, if an investor has an account geared toward saving for retirement (IRA, etc.), another for college savings (529 plan), and a third to serve as a bill-paying reserve—this is one form of goals-based investing. A typical approach is that investors have more equities (risk) in a retirement account while the emergency reserve may hold less-risky investments like bonds or cash per Figure 31.1. The power lies in the fact that if these accounts are viewed as “untouchable” (college funds or retirement funds, for example) and investors may be less inclined to disturb long-term investment plans by making changes that could cause long-term accumulation problems. For risk-averse investors, mental accounting can help investors feel more comfortable taking on the risk they may need to reach specific goals.

This “bucketing” approach is particularly helpful for people who may be approaching the actual time of their retirement. As their focus shifts from saving to spending, many retirees need to tap their “retirement bucket” to fund their lifestyle. Many people who use this approach leverage three separate pools of capital to assist during this transition. These are: (a) a cash account for safety, (b) a short-term fixed income account (i.e., short duration) so you are earning income but still reasonably safe, and (c) a third longer-term pool of capital that is intended to keep up with growth and inflation.

Consolidating Accounts into a Portfolio View

One of the main “problems” with mental accounting is that it can produce inefficiencies if too many accounts are used for “safe” assets such as cash. For example, if you have too many “rainy day” or savings accounts you can lose out on long-term appreciation by not investing the pools of cash as one portfolio. To correct this, if you recognize that this mental accounting is happening you can consolidate accounts that are focused on the same goal—retirement, for example. If you have several retirement accounts, a few IRAs or 401ks that have come about from job changes over the years, try folding them all into a single account which you can then monitor and manage as a single portfolio. If not, it can be difficult to monitor funds and allocations, and therefore risk, when investments are too spread out. Get organized!

Consolidating accounts according to their goals, to bring order to your finances, is recommended.

In sum, investors using this approach will typically first estimate how much should be invested in low-risk (capital preservation) assets to meet those needs and obligations. Next, riskier assets are considered to attain priorities and desires. Finally, even riskier assets are added to meet one's aspirational goals. Typically, investors will end up having a diversified portfolio using this approach, but the resulting portfolio may not be efficient from a traditional finance perspective. The lack of efficiency stems from the components of the portfolio being individually justified rather than based on modern portfolio theory that considers correlations between investments. However, investors may be better able to understand risk by using this methodology. As a result, investors may find it easier to adhere to investment decisions and portfolio allocations made using this approach.

Portfolio Approach

At my firm, Sunpointe Investments, we leverage mental accounting albeit in a slightly different way. Our approach categorizes assets by two broad categories—Risky Assets and Risk Mitigation Assets. And each of those categories is broken down further into four categories. Risky Assets contain “Growth Assets” and “Hybrid/Income Assets”. Risk Mitigation Assets have two categories: “Defensive Assets” and “Flexible Assets.” These broad categories (Risky Assets and Risk Mitigation Assets) allow investors to think about risk in a simple way—such as 60%/40% or 70%/30%. This leverages the tendency to want to “bucket” money according to mental accounts. This is a very effective way of reducing complexity and communication simplicity.

Each of these buckets can be scaled up or down based on investor objectives. Investor allocations are then built from this model based upon specific return objectives and risk tolerances. We use a concept of risk in these models that augments conventional parameters with concepts more specifically useful to portfolio management, such as the lowest likely portfolio return, the Sharpe ratio, and downside risk (an estimate of the probability of missing the stated return objective over a given time horizon). These measures provide a more complete view of the value added to (or subtracted from) a portfolio with the addition or deletion of various asset classes. If you want more information on this, visit www.sunpointeinvestments.com.