Portfolio goals in different layers or Mental accounting bias

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In one part of CFAI curriculum ( I think in “Individuals”) is mentioned that asset management favors an individual’s goals as short and long term objectives in different layers while in other parts such individual’s reasoning is considered as Mental accounting bias. Pretty confusing.
 
When you inherit 1m you will treat it differently than if you earn 1m. So say you now have 2m but in your mind you treat the 1m inherited as having less weight in your portfolio. Therefore you tend to invest/spend this money more easily than your hard earned cash. You will invest your earned cash in low risk investments because you can’t afford to lose this money, while the other 1m can be invested in more risky investments because you have less emotional attachment to it even if you lose it. Translated in time horizon, your hard earned cash will be invested in a long term goal while the inheritance in more short term less strategic goals.
 
Yes, I understand but if I differ cash earned by my salary and cash earned by lottery, it is mental accounting bias because cash equals cash anyway if I would loose it, there is no difference. In one kind of PM approach, individuals are encouraged to build different layers and invest according to long term or short term targets. In some other places of curriculum, this is also considered as some kind of “deviant” behavior or mental accounting. Thus, where is the border between normal portfolio investing in various layers according investor’s objectives and frenzied mental accounting bias?
 
This is what I understood
mental accounting ===> asset segregation
for example an individual will save bonus and consume his salary or vice versa. The money does not have the same allocation based on its provenance!
asset segregation ====> different risk buckets or portfolio layers
For example the individual then chooses to put funds from bonus in more risky assets (equity) and saving from salary in less riskier assets ( govt. bonds)
an Asset manager must think first about the long term objective of the client (a client outliving his asset is bad) but must take into account biases of the client otherwise the client may not stick with the established portfolio (short term market fluctuation) not letting the portfolio’s strategy to work
I hope that I understood your question and I answered it :)
 
Thanks Javad. Yes you understood. What I think it is individual manager’s approach to different clients. If manager’s assumes that particular client suffers by accounting bias, layer approach might not be as good for that client because it will feed his/her bias. For another client (f.ex. with gambler character) layer approach might be good solution.
 
So by studying behavioral finance are we trying to educate investors to act rationally or on the contrary, recognize that investors are less than rational and their portfolios sometimes will justifiably be sub-optimal? In other words feeding investor biases is not such a bad thing.
 
I don’t know but it’s funny. As Harrogath said, all those biases should be recognized against deviation from mean-variance portfolio. If there is no deviation, such bias, if any, would not be an issue. PM are not psychiatrists, thus biases are just recognized as the barriers in building efficient portfolio.
 
There is only one issue here Kroko
we do not try to transform the client into an R.E.M. But to make stick with a portfolio that satisfy his O&C and us :)
thus it is not the optimal portfolio and the less standard of living risk the more you can accommodate your client biases
 
Flashback wrote:
I don’t know but it’s funny. As Harrogath said, all those biases should be recognized against deviation from mean-variance portfolio. If there is no deviation, such bias, if any, would not be an issue. PM are not psychiatrists, thus biases are just recognized as the barriers in building efficient portfolio.
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Yeah.
Also something interesting is that Behavioral Finance does not look for efficient portfolios, but the most comfortable portfolio an investor could handle taking account its behavioral biases. Human beings are not machines, and it is much, much likely an investor is willing to lose some money (from not holding an optimum portoflio), than sticking to an optimum portfolio and battle against its fears, hates and emotions in order to hold such portfolio in the long term.
However, some investors can be educated to take risks and to overcome some cognitive biases (the most likely to overcome, because emotional biases are hard to beat), that’s a job for the PM (presumably).
 
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