Behavioral Finance and Your Portfolio. Michael M. Pompian

Preface

      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:

      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.

A Challenging Environment

      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:

      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.

Why This Book?

      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