Linking Behavioral Finance to the Individual IPS

We’ll be covering Reading 9 of the CFA L3 curriculum. Titled "Behavioral Finance and Investment Processes", this section is all about how behavioral finance fits into the actual investment process, and specifically how to classify investors and determine their risk tolerance based on their mental outlook etc. If you're new to behavioral finance we recommend you start at the beginning. 

While this reading ties together a lot of things it's also arguably the least important of the three behavioral finance readings in the sense that it is the least directly tested.

That said, some of the concepts and frameworks introduced provide a useful tool kit, particularly in the context of individual IPS questions where you have to identify the risk tolerance of a particular investor. So that's really the focus of this reading.[1]

Unifying Behavioral Finance and Asset Allocation
Before we jump into the specifics it’s helpful to anchor this reading into what we’ve already learned about why behavioral finance is so important.

Remember that individual investors are imperfect. We're subject to various biases, and some of these biases can be very hard to mitigate.

Behavioral finance offers a way to understand individuals and unify what they should do with what they want or are capable of doing. In this way we, as financial advisors, can create portfolio strategies that lead to acceptable if not optimal outcomes (satisfice).

This should make sense in the context of the CFA Level 3 exam. After all, the entire morning constructed response section is about portfolio management. It should be no surprise that key goals for a portfolio manager would include:

  • Getting you as an adviser to understand a client
  • Getting you, as an adviser, to maintain a consistent approach
  • Having you, the adviser, really understand and act as the client expects you to act
  • Laying a foundation for mutual understanding

To summarize

The end goal is to develop a strategic asset allocation plan that is as close to efficient, where efficient is defined by modern portfolio theory and traditional finance, while also designing something that the individual can both understand and stick with during market highs and lows. To do this we need to understand where an investor is coming from.

While Reading 7 is an important synthesis of behavioral finance and a foreshadowing of its link to portfolio management it is also arguably the least important of the Behavioral finance readings in the sense that it is less directly tested than the individual behavioral biases.


How the CFA L3 Tests Behavioral Finance Investment Processes

Before we go into the specifics of the material, one thing to note is that the examples in the CFA L3 curriculum reading aren't necessarily great examples of how this material gets tested.

To really understand how the concepts are tested you should actually go skim a few IPS questions in the previously released level 3 morning mock exams (something our clients have access too).

This will give you a better sense of how these types of concepts get tested in the constructive response section, and equally important it'll also become very clear to you what type of information is typically given in a passage from which you must then determine an individual's risk tolerance. 

Investor Classification Frameworks for L3

In terms of the specifics of the reading, there's really five things that get introduced:

  • Two overarching strategies for investing assets
  • Three specific frameworks for classifying investors

BF R7 Outline

Framework 1: Goal Based Investing

The first framework is goal-based investing, and this is really similar to behavioral portfolio theory which we covered earlier in Reading 7.

Recall that with BPT the idea is that you build a portfolio layer by layer to meet different goals depending on your risk tolerances for those goals so your lower-risk assets are invested or designed to meet your key spending needs. Then as you move up this pyramid you take greater risks to meet less essential needs, which is to say there's an inverse relationship between your risk tolerance and your level of need. Goal Based Investing (GBI)

Problem with Goal Based Investing

So the problem with goal-based investing is that each level of this pyramid is constructed or individually justified without pausing to understand how the different layers are correlated to one another, and that's why it violates the traditional finance idea that assets are fungible, and that you need to look at your portfolio in a holistic way that considers asset diversification across different buckets.

Framework 2: Behaviorally Modified Asset Allocation (BMAA)

Behaviorally modified asset allocation, BMAA, is a strategy that looks to integrate as many elements of traditional portfolio theory as possible while also understanding where clients might deviate from that ideal, perfect, rational economic actor. The mechanism by which BMAA tries to build this understanding is a survey.

The end of goal of BMAA is to create some freedom for clients to deviate from that optimal, rational portfolio, while striving to design an investment strategy that integrates key tenants of MPT and thus sits as close to the efficient frontier possible.

So there's six steps to engage in BMAA (don't expect the specific steps to be tested, but it is helpful to understand what they are).

The six steps are:

  • Build what their efficient portfolio would look like
  • Then you look at their financial situation and understand the degree of risk that they're able to take[2]
  • Then you look at the nature of their cognitive and emotional biases. Again, we've talked at length about how cognitive biases are easier to mitigate than emotional biases.[3]
  • Once you have the standard of living risk, the type of biases, and the background of an investor, you establish their standard of living risk
  • Establish the acceptable standard deviation that's allowed 
  • Make asset allocation decisions

Investor Classification Models for the CFA L3 Exam

So GBI and BMAA are the two main frameworks introduced in Reading 7. What we’ll cover next are the three main investor classification models. 

For the exam, you might going to need to classify an investor according to the Barnwell Two-Way model, maybe the BB&K, maybe the Pompian model, according to given information.

But really, it's more likely that you have to look at a long passage and figure out if an investor has average, below average, or above average ability or willingness to take risk.

Think of the following models as frameworks that give you hints as to what bucket that investor might fall into. 

General Limitations to Classifying Investors

Before we actually dive into the actual classification schemes, it's probably important to call out the fact that there's limits to these behavioral classifications in the first place. Namely:

  • An individual might not fit neatly into a bucket

They could have emotional and cognitive biases and they are displaying them at the same time. They might behave as if they are multiple different types of investor, based on these models.

  • Investors change over time 

What applied to a client when they first came into your office as a 30 year old could well change as they near retirement, for example.

  • There is a lot of variation within these buckets

These schemas are just large buckets to group people within. There can be a lot of variation between people within the same bucket.

  • Behavior can change suddenly depending on external factors

This is really an important point. Even if you've classified an investor perfectly, their behavior could be unpredictable at the most random of times, often the result of market extremes.

So inherently, any classification is a simplification of how you actually have to deal with individuals. With these limitations established let's jump into the three models.

The Barnwell Two-Way Model

The Barnwell Two-Way model really just divides investors into active and passive investors. There's a couple telltale signs for each.

An active investor is someone who's usually risked their own capital to gain wealth. They’re entrepreneurs. Barring that, they’ve displayed, historically, an active role in investing their own money. As a result they tend to be more experienced and more comfortable with risk, particularly when they feel in control of that risk. One tell-tale sign on the exam: an individual who is comfortable holding a concentrated position.
For passive investors the telltale sign on the exam is that they've not risked their own capital to gain wealth. So they could have inherited money, there also could just be long term savers who have had not a risky job and have saved money over time from that steady job (think teachers, unionized workers). In contrast to active investors, passive investors are more risk-averse and cautious.

So Barnwell Two-Way model: active and passive, fairly simple. 

The Bailhard, Biehl, & Keiser (BB&K) Five Way Model

The BB&K five way model really just builds on some of the principles of the Barnwell classification scheme. Only now we’re dealing with two axes to classify investors:

  • On the Y-axis you have how confident an investor is.
  • On the X-axis you have how carefully they consider and act on decisions

 BB&K Five Way Model - CFA

So there's really five investor types, depending on how careful or impetuous they are, how confident or anxious they are, and the straight arrow is sort of a blend of each. Think of the straight arrow as the closest to behaving like a rational economic actor. 

Pompian Behavioral Model

And then, last but not least, you have the Pompian behavioral model. This schema divides investors into four different types, where each type is determined using a four-step behavioral interview.

On the L3 exam you will not need to know the steps, but basically, you interview the client to determine if they're active or passive—i.e. you create a proxy for risk tolerance. Then you plot the risk tolerance on a scale, and test them for individual behavioral biases. Finally you classify the individual into one of the four categories. And the four categories are: the Passive Preserver, the Friendly Follower, the Independent Individualist, and the Active Accumulator.

 Pompian Behavioral Model

So they really love their alliteration here, but that can be helpful. So as you can see in the table, there's a lot of parallels to the BB&K model, and you should sort of memorize the risk tolerances, the investment styles, the dominant biases and perhaps, on the right here, the types of emotional biases and cognitive biases that get displayed.

Summarizing Behavioral Finance Classification Frameworks

So just to summarize, you have these two frameworks or classification investment models, and then within that, three sort of more detailed models for classifying investors: BB&K Five Way model, Barnwell Two-Way behavioral model and the Pompian behavioral model. And really, at the end of the day, it's all about understanding the risk tolerance of investors, whether those individual quirks that they're displaying are things that can be accommodated or mitigated via standard of living risk and being able to do all of this in terms of a lengthy passage in an IPS question that sort of talks about the history of an investor, their financial situation, and some of their beliefs.

So that's Reading 9. Again, it sort of builds on Reading 7 and 8, which compare traditional finance and behavioral finance and then go into the specific individual biases. Those two readings tend to be tested more directly, while this one offers a tool kit for looking back through passages and sort of classifying investors as a means to decide if their risk tolerance is below average, average, or above average. 


[1] One thing to note for sure that's very important here is that the examples in the curriculum reading aren't necessarily great examples of how this material gets tested. What you should actually go do is skim a few IPS questions in these morning mock exams, and that will give you a better sense of how these types of concepts get tested in the constructive response section, and it'll also become very clear to you what type of information is typically given in a passage where you can determine an individual's risk tolerance. 

[2] where we try to get as close to efficient as possible, where efficient is defined by modern portfolio theory and traditional finance, while also designing something that the individual can both understand and stick with during market highs and lows. 

[3] That's basically a standard question on the morning IPS section, so you're guaranteed to need to answer individual risk tolerances of an investor.

[4] If you can, you often need to accommodate, because they're less rational they're not coach-able to the same degree