04 March 2022

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Portfolio and behavioral allocation

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The most important decision when investing money is how to divide it among the various asset classes. There are two steps:

• Identify the volatile allocation (categories of assets subject to some price risk: usually, stocks. To invest in them, we can use specific financial products, such as mutual funds and/or ETFs);

• Identify the complete allocation (composed of a volatile one and a monetary asset, suited to your risk tolerance or our needs: deposit accounts and/or

Before arriving at the complete allocation, let's focus on what we can call " behavioral allocation. "As confirmed by behavioral finance studies, many people operate contrary to what is suggested by the Modern Portfolio Theory: 

• They do not treat risk objectively (we tend to overestimate risky events with a low probability of occurrence);

• They do not demonstrate a uniform risk attitude (one can be risk-averse in some contexts and risk-loving in others). 

So, to try to increase the expected return of the allocation by taking on more risk, one would prefer to take much more risk with just one part of the money. According to the Modern Portfolio Theory, this choice does not make sense, as we should understand the allocation as a whole, possibly taking a little more risk with all the money available. Behavioral investors (often to satisfy the aspiration to significantly improve their lifestyle) choose to dial the volatile allocation only with the asset class they believe has the most potential, albeit very risky: they prefer portfolio concentration over-diversification (chosen assets can be even riskier than mid-and large-cap stocks, such as single stocks or derivatives, or solutions with a negative expected return, typically lotteries).

For example, it is assumed that an investor decides to bet on smaller cap stocks, considered on average to have the highest expected return, but also riskier. Hence, the behavioral allocation is composed of small-capitalization shares with a weight of a total of 100%. The behavioral allocation is based on a heuristic technique:

• It does not require you to estimate the expected return of the shares, the expected volatility of the assets, and the expected correlations between the various pairs of categories;

• Does not diversify between investments using a mathematical optimization process (prefers concentrated allocations).

The problem with behavioral allocations is that they can be riskier than those built with Modern Portfolio Theory and may not be suitable for a large number of investors.

Moving on to full allocation, in order not to put all our financial wealth at risk, we must also invest in monetary activity (its presence can be justified by the need to have liquidity immediately and easily available: for example, to face unexpected events, such as a decline in income or an increase in expenses). Assuming an investor who decides to keep a share of monetary assets equal to 30% of the total full allocation, the pie that the categories of volatile assets must divide is 70% (in our example, monetary assets with a weight of 30 % and small cap stocks with a weighting of 70%).

Speaking of risk, with the data updated at the beginning of March 2021, it is possible to assign a price risk of -38% to this complete allocation that invests globally (investing $100,000 we must accept that in the very short term, in 5% of the years more unfortunate, wealth could drop by an average of $38,000).

If this decline is considered excessive/deficient both from a financial and psychological point of view, the share of monetary activity must be increased/decreased. Having decided which full allocation is right for us, we need to choose which financial products to use in practice. On the market, it is possible to invest directly in individual securities or in asset management products (mutual funds, ETFs, etc.). 

Finally, the time variable must always be taken into consideration: over time both the prices of volatile assets and our risk tolerance change. Therefore, it is important in the allocation process to decide how often to recalculate the complete allocation (establish the new percentage shares of the various activities). Rely on professionals and avoid do-it-yourself.