Portfolio Management

CHAPTER 15Investor and Client Behavior

Chapter Outline

1. 15.1 Introduction
2. 15.2 Theory and Observations of Human Behavior
3. 15.3 Implications for Active Management
4. 15.4 Implications for Setting Investment Policy
5. 15.5 Implications for Manager Selection
   1. Summary
   2. Problems
   3. Endnotes

15.1 INTRODUCTION

As a fiduciary, an investment manager is required to do what is best for his or her client.¹ To address clients' needs effectively, the investment advisor must understand not only the clients' cash flow requirements but also their motivations and preferences. The theory and models reviewed in earlier chapters reflect specific client motivations and preferences. However, empirical and anecdotal observations of investor behavior suggest that these assumptions can be incomplete; for example, individuals often appear to consider factors beyond risk and return when making decisions. The result is investor behavior that is sometimes at odds with theory. It is not that people are irrational or are not interested in maximizing wealth. Rather, it appears that the decision-making techniques that work well as survival tools in the natural world do not necessarily translate into success in the financial world and common investor behavior can frequently lead to poor outcomes. An understanding of these differences will help advisors alert clients to potential errors in judgment, even though the mistakes may appear to make sense, may be the conventional wisdom, or may even be considered standard ...