Complete Contradition in Individual vs. Institutional IM Approach behavioral, desires, completely, essential, structure

ASSet_MANagemen

So as I review the notes in the behavioral finance stuff, having just reviewed the insitutitonal IPs stuff, I find both these sections to be completely contradictory.

To summarize - the behavioral finance section makes a big deal about individuals being idiots and "pyramiding" their portfolios, with "essential" future needs at the bottom, and "aspirational" desires at higher "layers". Per the text, to put it bluntly, is a BAD way to structure a portfolio.

My question - how is that so different than what institutions do? Insurance companies, banks, DB plans - they all have "essential" liabilities that need to be fulfilled, which they usually cover with fixed income instruments/duration matching, etc. Then use surplus to be more aggressive and grow. Uh...isn't this pyramiding as well?

Honestly, I don't understand why the CFA makes a big deal out of modern portfolio theory being a "better" approach to pyramiding when most of the big institutions do the same dang thing. Makes me think this CFA stuff is more focused on theory than practicallity?

ohai

I think "behavioural finance" itself is still under academic debate.

There are many scholars wouldn't accept it into main stream financial theory.

skycfa

wangta01, yes pyramiding does conflict with modern portfolio theory. But the people behind behavioral finance disagree with modern portfolio theory. You say that pyramiding disagrees with CFA. That's not true. CFAI is presenting behavioral finance as an ALTERNATIVE to modern portfolio theory. They are not explicitly endorsing or condemning either approach.

lcai

The materials are a collection of books not written per se by the CFA Institute themselves. Contradiction is of course expected.

NakedPuts2011

Nitz25 Wrote:
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> Future cash payments for children's college
> tuition
> vs.
> Future cash payments for policy holder's annuity
> payouts
>
> Both are future liabilities for which you could
> create a separate portfolio of conservative fixed
> income assets with matched durations. CFA says
> one approach is a behavioral bias and the other is
> a institutional best practice.
>
> That's the similarity and the contradiction.

EXACTLY!

Chuckrox

Lobsterboy - actually they do say pyramiding is bad. Pyramiding = segmenting portfolio, which by CFA and modern portfolio theory, is sub-optimal. And yes, you're right - the lower (or lowest) level are the low risk assets, which are specifically chosen to satisfy the individual's critical goals (college for kiddies) - this seems eerily familiar to an insurance company IMMUNIZING their actuarial assumed liabilities, no?

Then, when the individual has "satsified" or immunized their most important liabilities, they move up the pyramid and focus on higher risk/higher return securities to hopefully achieve "desired" items - house in the hollywood hills. Again, that seems eerily familiar to a "surplus portfolio", which is invested in venture cap, private equity, etc.

If modern portfolio theory is so right and individuals shouldn't follow this segmented approach, I'd like to see banks, pension funds, etc. grow some nutz and use a "diversified portfolio theory" to satisfy all their return, risk needs.

But I digress...I'm going to go back to being brainwashed into CFA = god's law. The emperor is wearing really nice clothes...

Analti_Calte

I think the time horizon's are much much different between the two.

In an individual's case, when there is a big payment coming due and its soon, you are told to take the PV of it and ex it out of the investable portfolio.... just like the insurance companies do (separating the surplus / regular portfolio)....

Pretty consistent in that way

former

Paraguay Wrote:
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> One is to match liabilities in a very efficient
> and extremely precise manner. The other is to
> match assets in a less than efficient manner. I
> guess I don't see the similarity.

Future cash payments for children's college tuition
vs.
Future cash payments for policy holder's annuity payouts

Both are future liabilities for which you could create a separate portfolio of conservative fixed income assets with matched durations. CFA says one approach is a behavioral bias and the other is a institutional best practice.

That's the similarity and the contradiction.

Colum

its an interesting observation, but I'm w. janakisri on this one: let's indulge this to our hearts content next monday

jmh530

In behavioral finance theory, they are presenting an alternative to modern portfolio theory. Maybe you can call it "postmodern" portfolio theory. In any case, they are not saying pyramiding is bad. They're just saying that this is 1 way to structure a portfolio. Also, I think you're misinterpreting the pyramid. The lower layers are not the essentials. They are the low risk assets.