Trying to wrap my head around something. I get that cognitive biases are moderated and emotional biases must be adapted to BUT it’s noted that emotional biases will require portfolio modifications (they need a stronger asset allocation change).
How does adapting equate to portfolio modifications. To me portfolio modifications seems to be moderating or taking control of their decisions. Not understanding how thats adapting.
Thanks,…much appreciated.
it depends on the person’s wealth level ( does he/she have a risk of the living standard)? and what kind of bias it is as you mentioned ( cognitive errors can be moderated but the emotional bias is much harder). In general, the wealthier a person is, the lower is their living standard risk, and asset manager addresses the client’s bias based on how hard it is to correct the bias considering the nature of the bias and if it is vital to correct the bias.
if one is wealthy and has an emotional bias, there is pretty much nothing you can do or should do, you adapt, some billionaire insists on buying a villa in Italy because he is sure it is the best investment even though Italian economy is not doing too great and is deflating, alright then
so if one is wealthy and has a cognitive error, we don’t really need to moderate his/her bias since it is affordable, so what if he lose 1 million a year because he believes buying a Picasso is the best way to invest just because his godfather is Picasso’s off ( representative bias?)
but if one is poor and has an emotional bias you would try to adapt, and even moderate, it is risky for them to deviate from their goals as their kids’ tuition is at stake. There is a heavier price to pay, comparing to a wealthier individual to have the person’s IPS deviate from the ideal.
If one is poor and shows cognitive error, you have to moderate it, you are a pensioner and can’t afford to buy a declining stock of your firm because you believe you are contributing to it personally (illusion of control). This can’t happen because you will be on the streets if you lose your pension.
So the individual here (keller from one of the topic tests) --> he’s wealthy and emotional.
For this individual, he would need to be adapted to. The answer is he needs stronger asset allocation change (portfolio adjustement).
My question is moreso, how does portfolio adjustment equate to adapting? I see changing the asset allocation as moderation.
Love your response – Good read but I just wanted this specific part of the question answered and where my confusion lies,
Thanks…much appreciated.
which topic test is this?
Portfolio modification in this case => either the person is not wealthy or the biases are cognitive
And yes, portfolio adjustment means moderation.
the person can be wealthy but she might have a very concentrated portfolio thus her living standard risk is high so you need to moderate it even it is cognitive bias
Fisher Topic Test.
True statement is for Q1
A client’s cognitive errors can be moderated, but emotional biases will require portfolio modifications.
For Q1, I thought this was wrong.
For Q5.
Keller is a wealthy individual with emotional biases. Suggest a target allocation.
It chooses a Stronger asset allocation change. I choose a No asset allocation change.
I got both these answers wrong not understanding the portfolio modifications associated with emotional biases. Unless I’m reading the questions wrong.
This is why I’m soo confused.
Thanks
Cognitive = Moderate
Emotional = Adapt
Low SRL = Adapt
High SRL = Moderate
Thus Matrix would be:
Low SRL / Emotional = Adapt
Low SRL / Cognitive = Moderate
High SRL / Cognitive = Moderate
High SRL / Emotional = Moderate
Treat Emotional Biases with High SRL same as Cognitive biases with Low SRL.
Adapt = Emotional biases = Make allocation changes
Moderate = Cognitive biases = Educate to reduce those biases = Don’t make allocation changes
If an individual has High Wealth/Low SLR and has emotional biases, the client can afford larger allocation changes because assuming those changes involve more risk, they can afford the swings.
If an individual has Low Wealth/High SLR and has emotional biases, the client cannot afford larger allocation changes as they cannot afford the swings. Here we would adapt less or not at all and try to moderate the biases as much as possible.
I get the matrix
High wealth (Low standard of living risk) and emotional --> Response Adapt
Read my previous post. Why is portfolio adjustment consistent with adapting? That’s the answers in the Topic Test - Fisher.
JayWill…
YESSSS - Thank you.
It is confusing though. If you’re making portfolio adjustments makes it seem like moderation
If you’re deviating from the recommended policy allocation determined by evaluating the client’s circumstances, risk tolerance, time horizon and constraints, you’re adapting to the biases by allowing drift away from that recommended allocation. If you’re not deviating from the recommended policy allocation, it means you’re moderating the biases through education and not letting them influence the policy allocation.
Generally the biases are going to cause a client want a different allocation than what MVO says is the correct allocation. The goal is to steer them toward that allocation, but that can be difficult when emotional biases dominate. In that case, and assuming they can afford to drift from the proper allocation (High Wealth/Low SLR), you can adapt to the biases and let things get away a bit (or a lot).
And of course, you’re welcome!
Yeah, it’s a confusing topic. JayWill explained it perfectly. You either adapt to the person’s bias = deviate from the MVO portfolio, or you moderate their biases = keep the tgt allocation the MVO portfolio.
“The basic actions are to adapt to a bias or to moderate the impact of the bias. When a bias is adapted to, it is accepted and decisions are made that recognize and adjust for the bias rather than making an attempt to reduce the impact of the bias. The resulting portfolio represents an alteration of the rational portfolio; the alteration responds to the investor’s biases while considering financial goals and level of wealth. To moderate the impact of a bias is to recognize the bias and to attempt to reduce or even eliminate the bias within the individual rather than to accept the bias. The resulting portfolio is similar to the rational portfolio, and a program is adopted to reduce or eliminate the investor’s biases.”
my confusion first came from the fact that when we “adapt” we make drastic changes to the Asset allocation. Those changes we make are from an optimal portfolio (And not the clients current portfolio). If a client is highly emotional and thus their behavior is difficult to change, we would deviate drastically from an optimal portfolio in order to adapt to the clients needs and allow them to have comfort with the portfolio they have.
If we moderate, we make modest changes from the Optimal portfolio since the client has cognitive biases which are easier to fix thru educating the client. The client will be comfortable with the optimal portfolio as he/she is not emotional and after educating them will be able to grasp the optimal portfolio
The advisable deviation from an optimal portfolio should be dependent upon 2 factors: type of bias and standard of living risk.
Emotionally biased and low SLR then the client can afford to deviate more and take those extra risks.
Cognitively biased and low SLR then you should deviate less and try to educate the client correcting false assumptions
Emotionally biased and high SLR then you CANNOT deviate as much as when you have a low SLR but it is not always feasible to correct these biases. So, you may have to deviate slightly.
Cognitively biased and high SLR the client should deviate the least because the advisor should be capable of educating the client and correcting the false assumptions.
This is a great explanation.
When we talk about moderate vs adapt.
Moderate means we are going to change the portfolio (to optimal or close to optimal) so basically cognitive biases (both high and low SLR) and emotional w/ high SLR.
And then adapt - is basically meaning we’re not going to change. So this only really applies for emotion w/ low SLR.