Behavioral Portfolios in the Life Cycle

Coby De Kraker | Download | HTML Embed
  • Mar 3, 2014
  • Views: 20
  • Page(s): 20
  • Size: 1.08 MB
  • Report

Share

Transcript

1 Investment Symposium March 13-14, 2014 New York, NY Session # P1 Behavioral Portfolios in the Life Cycle Presenter Meir Statman

2 3/3/2014 Behavioral Portfolios in the Life Cycle Meir Statman Glenn Klimek Professor of Finance Santa Clara University Question If you could increase your chances of having a more comfortable retirement by taking more risk, would you: a. Be willing to take a little more risk with all your money? b. Be willing to take a lot more risk with some of your money? 1

3 3/3/2014 If you could increase you chances of improving your returns by taking more risk, would you: Risk Money a. A little x All of your = Addition to more risk money portfolio risk b. A lot more Some of Addition to risk x your money = portfolio risk What We Really Want Freedom from fear Downside protection Hope Upside potential Goal-based portfolios We want to be rich (10% chance to be rich) We dont want to be poor (Almost 100% chance not to be poor) 2

4 3/3/2014 What We Really Want Why do we put money in our portfolios? What will we do with it? Utilitarian benefits I have money for retirement Expressive benefits I am financially independent Emotional benefits I have freedom from fear (Downside protection) I have hope for riches (Upside potential) What We Really Want Why is wealth important to you? (SEI survey) 3

5 3/3/2014 Standard Finance and Behavioral Finance Standard Finance Behavioral Finance Finance with rational people Finance with normal people Computer-like people Normal-smart Normal-stupid Immune to cognitive errors and misleading emotions Normal-ignorant Normal-knowledgeable Why do we behave as we do? Behavioral Finance version 1 Behavioral Finance version 2 Because we are normal, pursuing what normal investors want Because we are irrational We fall victim to cognitive errors and misleading emotions on our way to what we want 4

6 3/3/2014 Foundation blocks of standard finance 1. Investors are rational 2. Investors should construct portfolios by the rules of mean-variance portfolio theory (and actually do so) Investors save and spend by life-cycle theory (Smoothing spending over the life-cycle) 3. Markets are efficient 4. Expected returns are determined only by risk (measured by beta (Only utilitarian factors) Foundation blocks of behavioral finance 1. Investors are normal 2. Investors construct portfolios by the rules of behavioral portfolio theory (and are wise to do so) Investors save and spend by behavioral life-cycle theory (affected by framing, mental accounting, and imperfect self-control) 3. Markets are not efficient (but are not as easy to beat as many normal investors think) 4. Expected returns are determined by more than risk (Utilitarian, expressive and emotional factors) 5

7 3/3/2014 Mean-variance portfolio theory Behavioral portfolio theory 6

8 3/3/2014 Mean-Variance Portfolios Theory vs. Behavioral Portfolio Theory Mean-Variance Portfolios Theory What do investors want? Investors want portfolios with the optimal combination of expected returns and standard deviations Behavioral portfolio theory What do investors want? Investors want to reach their goals (retirement, education, bequest) Mean-Variance Portfolios Theory vs. Behavioral Portfolio Theory Mean-variance portfolio theory Portfolios as a whole Investors consider their portfolios as a whole Investors have one risk attitude for their portfolios as a whole Behavioral portfolio theory Portfolios as pyramids of mental accounts Portfolios Investors consider their portfolios as pyramids of goal-based mental accounts and have as many risk attitudes as mental accounts 7

9 3/3/2014 Mean-Variance Portfolios Theory vs. Behavioral Portfolio Theory Mean-Variance Portfolios Theory Risk Investors measure risk by the standard deviation of the returns of their overall portfolios Investors are always (standard-deviation) risk-averse They never buy lottery tickets Behavioral Portfolio Theory Risk Investors measure risk by the probability of failing to reach thresholds of each goal in each mental account, by the shortfall from a threshold, or by a combination of both Investors are always risk-averse as measured by behavioral portfolio theory, but they can be (standard deviation) risk-seeking in some mental accounts Investors buy insurance but also lottery tickets Combining elements of mean-variance portfolio theory and behavioral portfolio theory into a mental-accounting portfolio framework Portfolio Optimization With Mental Accounts, Journal of Financial and Quantitative Analysis, 2010 Portfolios for investors who want to reach their goals while staying on the mean-variance efficient frontier Journal of Wealth management, 2011 Das, Markowitz, Scheid, and Statman 8

10 3/3/2014 The overall portfolio and goal-based mental accounts (sub- portfolios) are all on the mean variance efficient frontier Liability-Directed Investing (LDI) in Behavioral Portfolio Theory Das, Kim and Statman Liability Directed Investing (LDI), like behavioral portfolio theory (BPT), is centered on investors directed to optimal portfolios by their liabilities The liabilities of pension funds are to their beneficiaries The liabilities of individuals are their goals - liabilities to themselves 9

11 3/3/2014 Liability-Directed Investing (LDI) in Behavioral Portfolio Theory (BPT) Optimal BPT-LDI portfolios maximize expected terminal wealth subject to the condition that expected shortfalls from their liability (target terminal wealth) not exceed expected shortfall allowance We explore initial optimal portfolios and subsequent portfolios as they are rebalanced on the way to the terminal date Behavioral rebalancing is different from fixed-proportion and market-proportion rebalancing Behavioral rebalancing consists of moving from the optimal allocation in one period to the optimal allocation in the next period, given the changes in parameters, such as stock returns, during the preceding period Liability-Directed Investing (LDI) in Behavioral Portfolio Theory (BPT) Consider an investor with $500,000 today who sets her target wealth at $1 million by the terminal date, 20 years from today She is willing to allow a $150,000 expected shortfall from her target wealth at the terminal date We find the optimal initial portfolio for this investor and the optimal subsequent portfolios as she rebalances them each year on her way to the terminal date 10

12 3/3/2014 Liability-Directed Investing (LDI) in Behavioral Portfolio Theory (BPT) Our investor allocates a proportion, w, to stocks, and a proportion, 1-w, to risk-free bonds The return of risk-free bonds is rf = 3% Stock returns follow a normal distribution with an expected return = 7% and standard deviation = 20% (Later we consider stock returns that follow a non-normal distribution, reflecting an actual stock return distribution) The LDI-BPT efficient frontier 3.25 w = 100% 2.75 Expected Terminal Wealth 2.25 ($millions) 1.75 1.25 w = 14.57% w = 5.13% w = 0% 0.75 0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 Expected Shortfall ($millions) 11

13 3/3/2014 Optimal stock allocation is higher when shortfall allowance is higher There is no feasible stock allocation when initial wealth is too low 100 90 80 70 Optimal 60 Initial Stock 50 Allocation, w*, (percent) 40 W0 = 31.20% 30 20 W0 = 42.87% K = $150,000 10 K = $300,000 0 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Initial Wealth, W0, ($millions) We can find feasible stock allocations when initial wealth is too low by increasing shortfall allowance We get a U-shaped optimal stock allocation: Stock allocation is very high when initial wealth is very high or very low 100 K = $500,000 90 80 70 w*: Optimal 60 Initial Stock 50 Allocation K = $300,000 (percent) 40 30 20 K = $150,000 10 0 0 0.1 0.2 0.3 0.4 0.5 0.6 Minimum Initial Wealth Necessary For A Feasible Portfolio, W0, ($ Millions) 12

14 3/3/2014 Remedies for infeasibility include increasing wealth (W), increasing investment horizon (N), increasing shortfall allowance (K), or decreasing target wealth (H) Panel A. Sample realized return path j Realized return Wj-1 wj* 1 N/A $500,000 30.76% 2 0% $500,000 29.37% 3 +10% $550,000 33.69% 4 -20% $440,000 infeasible --- --- --- --- Panel B. Remedies when portfolio becomes infeasible at j=4 Remedy Change K H N-4 Wj-1 wj* Do nothing --- $150,000 $1,000,000 16 $440,000 infeasible Increase Wj $33,100 $150,000 $1,000,000 16 $473,100 14.65% Increase N 3 $150,000 $1,000,000 19 $440,000 20.76% Increase K $39,300 $189,300 $1,000,000 16 $440,000 19.58% Decrease H $55,200 $150,000 $994,800 16 $440,000 16.19% What We Really Want We want a dignified retirement life Problem: Many do not save enough for retirement Reasons: Inability to properly allocate earnings to spending and savings over the life cycle Inability to earn enough for spending and savings 13

15 3/3/2014 We Want to Save for Tomorrow and Spend it Today The Problem of Self-Control Standard life cycle theory assumes perfect self control Behavioral life cycle theory assumes imperfect self control Save for Tomorrow Spend it Today We Want to Save for Tomorrow and Spend it Today The benefits and difficulties of self-control Genetics account for one-third of differences in saving behavior Self-control is associated with conscientiousness (One of the Big-Five factors of personality) Conscientious people tend to excel academically and at jobs, have stable marriages, and live long Not everyone is conscientious 14

16 3/3/2014 We want retirement savings protected from weak self-control Retirement savings in the old mandatory DB paternalistic days Voluntary Savings (Libertarian) Mandatory Defined Benefits (DB) Retirement Savings (Paternalistic) Social Security (Paternalistic) Markets and politics make defined-benefit pensions impossible 15

17 3/3/2014 We want retirement savings protected from weak self-control Retirement savings in the early voluntary libertarian DC days Voluntary Savings (Libertarian) Voluntary Defined Contribution (DC) Retirement Savings (Libertarian) Social Security (Paternalistic) We want retirement savings protected from weak self-control Retirement savings in the more recent voluntary libertarian-paternalistic (Nudge) DC days Voluntary Savings (Libertarian) Voluntary Defined Contribution (DC) Retirement Savings With a Nudge (Libertarian - Paternalistic) Social Security (Paternalistic) 16

18 3/3/2014 We want retirement savings protected from weak self-control Retirement savings in my proposed mandatory paternalistic (Shove) DC days Voluntary Savings (Libertarian) Mandatory Defined Contribution (DC) Retirement Savings With a Shove (Paternalistic) Social Security (Paternalistic) What We Really Want We want a dignified retirement life Problem: Many do not save enough for retirement Reasons: Inability to properly allocate earnings to spending and savings over the life cycle We can help them with nudges and shoves Inability to earn enough for spending and savings How do we help them? 17

19 3/3/2014 We want a dignified retirement life We can help those Inability to earn enough for spending and savings Conclusion Behavioral portfolio theory can offer descriptions of normal construction of portfolios and prescriptions for better portfolios Portfolios are accumulated by saving and decumulated by spending Behavioral life cycle theory can offer descriptions of normal saving and spending during the life cycle and prescriptions for better saving and spending 18

20 3/3/2014 Meir Statman Contact Information Meir Statman Glenn Klimek Professor of Finance, Santa Clara University 500 El Camino Real, Santa Clara, CA 95053, USA Tel 408 554 4147 [email protected] http://www.scu.edu/business/finance/faculty/statman.cfm http://whatinvestorswant.wordpress.com/ 19

Load More