Behavioral Finance and Your Portfolio. Michael M. Pompian

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Behavioral Finance and Your Portfolio - Michael M. Pompian


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       Library of Congress Cataloging-in-Publication Data

      Names: Pompian, Michael M., 1963- author.

      Title: Behavioral finance and your portfolio : a navigation guide for building wealth / Michael M. Pompian.

      Description: Hoboken, New Jersey : Wiley, [2021] | Includes index.

      Identifiers: LCCN 2021008937 (print) | LCCN 2021008938 (ebook) | ISBN 9781119801610 (hardback) | ISBN 9781119802006 (adobe pdf) | ISBN 9781119801993 (epub)

      Subjects: LCSH: Finance—Psychological aspects. | Investments—Psychological aspects. | Investments—Decision making.

      Classification: LCC HG101 .P658 2021 (print) | LCC HG101 (ebook) | DDC 332.601/9—dc23

      LC record available at https://lccn.loc.gov/2021008937

      LC ebook record available at https://lccn.loc.gov/2021008938

      Cover Design: Wiley

      Cover Image: © sorbetto/DigitalVision Vectors/Getty Images

      Founded in 2016, Sunpointe Investments is a wealth management firm that also creates books and articles. Sunpointe is committed to developing first class research and investing content for individuals and financial advisors. Content topics range from portfolio management to behavioral finance and much more.

      For a list of article and books, please visit our Web site at www.sunpointeinvestments.com.

      This book is dedicated to my three sons Nicholas, Alexander, and Spencer.

      If successful, this book will change your idea about what an optimal portfolio is. It is intended to be a guide to both understanding irrational investor behavior and creating portfolios for individual investors that account for these irrational behaviors. In this book, an optimal portfolio lies on the efficient frontier, but may move up or down it depending upon the individual needs and preferences of you as an individual investment decision-maker. When applying behavior finance to real-world investment portfolios, an optimal portfolio is one that an investor can comfortably live with, so that he or she has the ability to adhere to his or her investment program, while at the same time reach long-term financial goals.

      Given the run-up in stock prices from 2009, in the wake of the global financial crisis, to 2020, and the bear market brought on by the novel coronavirus, understanding irrational investor behavior is as important as it has ever been. This is true both for the markets in general, but most especially for individual investors. The intended audience for the book is sophisticated individual investors who wish to become more introspective about their own behaviors, and to truly try to understand how to create a portfolio that works for them. The intention is that it is a guidebook, to be used and implemented in the pursuit of building better portfolios. When considering behavioral finance, investors rightly have questions. Some of these are:

       What are the most common investor biases that cause investment mistakes?

       What are the most impactful biases?

       How do I create the best allocation for me, taking into consideration my behavioral tendencies?

       How do I stick to a long-term investment plan?

       Should I buy individual stocks or stick to a diversified portfolio?

      This book will answer these questions. There is difference between this book and my prior books. Most of my prior work has been written through the lens of how financial advisors advise: That is, how financial advisors can work better with their clients. This book, however, is written from the point of view of the investor. The only part of the book that has the financial advisor perspective is the case studies at the end. This is intentional. I want you, the investor, to pretend you are an advisor. This way you can implement the lessons in the book, which will drive home the learning.

      In the last 25 years, the interest in behavioral finance as a discipline has not simply emerged, but rather exploded onto the scene, with many articles written by very prestigious authors in prestigious publications. We will review some of the key people who have shaped the current body of behavioral finance thinking, and review work done by them. And then the intent is to take the study of behavioral finance to another level: Developing a common understanding (definition) of behavioral biases in terms that advisors and investors can understand, and then demonstrate how they are to be used in practice through the use of case studies—a “how-to” of behavioral finance. We will also explore some of the new frontiers of behavioral finance, things not even discussed now that may be common knowledge in 25 years.

      Investors have never had more challenging times to invest in. Many investors thought they had found nirvana in the late 1990s, only to find themselves in quicksand in 2001 and 2002. And then we had the bull market of the 2000s only to get taken down by the 2008–2009 Great Recession. Today, we have had the longest bull market in history interrupted by the novel coronavirus bear market. In today's environment, as well as in the past, investors are continuously asking themselves:

       “Is asset allocation important or should I concentrate my investments?”

       “Should I invest in alternative investments?”

       “Should I have any bonds?”

       “Should I take the same approach to investing in college money as retirement money?”

       “Should I hold cash or stay fully invested?”

       “How should I modify my portfolio allocation based on my behavioral biases?”

      To that end, investors need a handbook like this one that can help them deal with the behavioral and emotional side of investing, so that they can help themselves understand why they have trouble sticking to a long-term program of investing. By implementing the lessons in the book, you too can reach financial goals.

      When I began taking an interest in how portfolios might be adjusted for behavioral biases back in the late 1990s, when the technology bubble was in full force, I sought a book like this one, but couldn't find one. I did not set a goal of writing a book at that time, I merely took an interest in the subject, and began reading. It wasn't until my wife, who was going through a job transition and came home one night talking about the Myers-Briggs personality type test she had taken, did I begin to consider the idea of writing about behavioral finance. My thought process at the time was relatively simple: Doesn't it make sense that people of differing personality types would want to invest differently? I couldn't find any literature on this topic. Fast-forward to today and this is my fifth book, and one that brings together a “greatest hits” of my work.

      As a wealth manager myself, I have found the value of understanding the


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