Behavioral Finance and Your Portfolio

31Behaviorally Aware Portfolio Construction

The difference between successful people and really successful people is that really successful people say no to almost everything.

—Warren Buffett

Introduction

The Behavioral Finance Approach to Asset Allocation Based on Mental Accounting

Leveraging the power of mental accounting for the benefit of attaining financial goals can be powerful. Our biases aren't necessarily harmful! There are two main topics in this chapter. First, we are going to discuss how a behavioral finance or a “goals-based” approach to asset allocation can be helpful in order to keep financial goals in mind when creating a portfolio. I have found the following approach, outlined in Figure 31.1, and based on investors' tendency to put money in separate mental accounts, to be of tremendous value at times. Not every investor likes or needs this approach to investing but some really like it. The second will be my firm's approach to asset allocation that leverages mental accounting but in a different way which we will explore later in the chapter.

Figure 31.1 Behavioral Finance or Goals-Based Approach to Asset Allocation

Generally, what investors should aspire to do is focus on their needs and obligations, and make sure that they have enough of their portfolio carved out in capital preservation assets to meet those needs and obligations. Next, if desired, ...