Influence of Behavioral Factors on Portfolio Construction

Various biases affect portfolio construction in different ways. The following are some of the common and testable biases and their consequences. 

• Status quo bias: This bias is characterized by inaction. Investors may choose the asset allocation and contribution rate default settings the plan sponsor offers. Furthermore, investors may not make the necessary updates to the plan as time passes, resulting in a less-than-optimal portfolio over time.

  Target date funds are intended to mitigate this investor tendency. Investors choose their preferred retirement date, and the fund manager automatically shifts the fund’s allocations to a more conservative mix in line with the investor’s target retirement date. While this may sometimes represent an improvement, a target date fund alone is not a full financial plan. It will not result in perfectly optimal portfolios since many other factors are not considered.

• Naive diversification: This bias occurs when investors skip the available traditional mean-variance optimization processes and instead choose a random number of funds to invest in and then another random allocation within those funds. For example, an investor may choose a stock, bond, and money market fund and allocate \(\frac{1}{3}\) of the contributions to each. The chances that this exact portfolio would have been produced following traditional finance and modern portfolio theory are very minimal. This way, the investors avoid the regret of missing the best performer.

• Concentration in employer stock: Employees are likely to exhibit this bias due to familiarity and overconfidence. Employers often offer matching incentives and discounts on company stock, which can tempt employees into over-concentrating on employer stock. This causes an elevated level of risk to the employee since, in such a scenario, their income and portfolios rely on the financial health of their employer. Best practice involves de-linking income and portfolio performance whenever possible.

• Excessive trading: Unlike the status-quo bias, which often occurs in retirement portfolios, excessive trading is the opposite end of the spectrum. Investors incur unnecessary commissions, taxes, and trading costs in excessive trading. In addition, they tend to underperform the market while attempting to time its movements. This occurs more often in taxable brokerage accounts and is likely rooted in overconfidence and self-selection bias. Further, the disposition effect manifests itself when investors hold onto losing positions too long, yet they sell their winning positions too soon.

• Home bias: Investors tend to concentrate their portfolios on their home countries. Portfolios resulting from this approach are likely to be suboptimal since mean-variance analysis is not considered. Availability bias comes to the forefront as a possible cause of this bias since investors are likely to have better access to news, media, and information about their local regions than foreign regions.

Question

Which of the following is least likely an advantage of a target date retirement fund?

1. It provides sufficient diversification.
2. It uses an appropriate time horizon.
3. It accounts for the correlation among assets of the total portfolio.

Solution

The correct answer is C:

A and B are potential solutions to naive diversification and status-quo biases.

C is incorrect: A target retirement date fund does not account for correlation among all investor assets (total wealth), which is a shortcoming in building optimal portfolios.

Reading 2: Behavioral Finance and Investment Processes

Los 2 (c) Discuss how behavioral factors influence portfolio construction