Journal of Financial Planning: February 2018
Executive Summary
In standard practice for financial planning, at least two competing demands are placed on the asset allocation process: taking on risk
to help clients reach their financial goals, and decreasing risk to keep clients from panicking and abandoning the plan.
To manage these competing demands, financial planners can apply two approaches: a risk capacity approach that focuses on goals and generating the required returns; and/or a risk preference approach that seeks to avoid panic. In isolation or in combination,
these two approaches may fail to help clients reach their goals and forestall panic.
This paper presents a third approach to helping clients. This behavioral approach brings behavioral interventions into the investment process and can potentially relieve the burden of these competing demands on asset allocation.
To understand the benefits and limitations of each approach, this paper presents results from a novel simulation model of investor behavior. The model demonstrated how investor panic resulted in a loss of between 8 percent and 15 percent of assets over a 10-year period, under standard risk capacity-based asset allocations and risk preferenceadjusted glide paths. The results were robust to a range of model specifications and assumptions.
In moving from a standard approach of risk preference, adjusting glide paths to the proposed behavioral approach, investors may receive a net increase of 17 percent to 23 percent in assets over 10 years.
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