Preface

The insight that inspired this book emerged in the spring of 2010 during an otherwise typical investment advisory discussion. My client, Rick, had investment needs. Like many investors, he wanted a conservative approach (low volatility) to managing his investments. Also like many investors, he simultaneously needed growth to increase his purchasing power. An inherent conflict. Thus, Rick called me to seek guidance on how to assemble a portfolio that would best meet his goals.

But Rick wasn't just any client. Rick was my longtime friend of more than 55 years. In the eighth grade, we played soccer together. In high school, we (along with our teammates) won the 1962 Pennsylvania State Championship. June 3, 1967, we entered Navy officer candidate school in Newport, Rhode Island together.

In 1970, I left active duty to join the finance industry. Rick went on to become a career Naval officer, rising to the rank of Captain in the Naval Supply Corp and earning a master's degree in computer science at the Navy's postgraduate school in Monterey, California along the way. He also prudently saved and invested his entire adult life.

Those of us who have the benefit of lifelong friendships know how special they are, especially at Rick's and my age. We shared a significant part of our youth together. Each of us was proud to serve our country. We each appreciate the career achievements of the other. And, importantly, we tease each other over minor missteps when we were young and a few misadventures we each have experienced as adults. There is an irreplaceable comfort in high quality, mutually respectful lifelong friendships.

Today, Rick and his lovely wife Dana have two children and three grandchildren. His personal goal is to provide for Dana on his death, and for his children and grandchildren on the death of the survivor.

Thus, when he turned to me in the spring of 2010 for investment advice, I was keenly aware of the discipline and sacrifice it took for him to assemble his portfolio. And I was intimately aware of the individuals who were trusting me for advice. So, as with any client, I took my advising role with Rick very seriously.

Rick knows from personal experience that markets are volatile. He also understands that at our age if he suffers a significant loss, he may not have time to recover. Thus, like many people, he prefers a conservative approach to managing his investments. Yet, his conservative bias is in conflict with another of his investment goals. Rick knows he must increase his purchasing power over time to maintain his standard of living. To increase purchasing power, investors must stay invested over reasonably long periods of time. Therein lies the rub: Rick is an action-oriented guy. Staying invested through good times and bad is at odds with his no-nonsense mentality of, "Don't just stand there, do something!" when things get rough. When volatility strikes, he (like many others), wants to reduce his volatility and chances of loss, even if that means reducing the chances for growth. In short, Rick's conservative (low volatility) approach was stymying the growth component his portfolio needed.

As I thought about Rick's investment goals and risk tolerance, I intuitively saw that by establishing specific goals (low volatility, growth) for each purpose, I could confidently recommend a tested Brinker Capital investment strategy that I believed had a high probability of achieving each goal. I knew in periods of market volatility, I could point out the stability of the low volatility or safety allocation and note that, over time, the more volatile growth or accumulation allocation would compound and create more purchasing power. I now know what I had solved for Rick is the dilemma psychologists call "simultaneous risk preferences."

A Strategy

With this broad investment policy in mind, two different Brinker Capital investment strategies were selected initially to implement it. Each strategy is from Brinker Capital's mutual fund asset allocation program known as Destinations. Brinker Capital has eight different investment programs, with each based on the same multi-asset class investment philosophy that seeks to reduce volatility, while maintaining the opportunity for appreciation. Rick's initial portfolio investment strategy is pictured in Table P.1.

Table P.1 Rick's Initial Portfolio Investment Strategy

Source: Brinker Capital, Inc. For illustrative purposes only.

What I had intuitively done was use mental accounting, or buckets, to frame a portfolio investment strategy that both would create the investment experience Rick wanted and allow me to communicate with him in terms that he easily understands. Thanks to decades of research into human behavior we now know people naturally collect and simplify information through mental accounting. Framing information into discrete buckets allows for faster comprehension and more rapid decision making. This communication format creates an ongoing level of understanding that enables the management of normal biases through his investment life cycle.

Following implementation of this strategy for Rick's portfolio, in the second half of 2010, investors in equities achieved very attractive returns. Our Destinations Moderate model, as part of the Accumulation allocation, was up +16 percent during this period (as of December 31, 2010).

With ten months of experience, Rick became comfortable with the performance of his portfolio investment strategy. In the spring of 2011, I suggested to Rick that allocating 70 percent in Destinations Defensive was much too conservative. He agreed. I then proposed, and he accepted, a change in his portfolio investment strategy.

We reallocated the 70 percent that was in Destinations Defensive: 35 percent to Destinations Conservative (a slightly less conservative strategy) and 35 percent to Crystal Strategy I Absolute Return, a global macro hedge strategy. His new reallocation is pictured in Table P.2.

Table P.2 Rick's New Portfolio Investment Strategy

Source: Brinker Capital, Inc. For illustrative purposes only.

By framing the portfolio investment strategy discussion and the performance discussion through the prism of mental accounts or buckets, Rick could easily see that:

• Using a Destinations Conservative strategy for his Safety bucket, a significant portion of his portfolio (35 percent) has the ability to remain stable during volatile periods. Knowing that his portfolio's safety is established, he can manage and put into perspective the pain of the more volatile accumulation strategy.
• Using Crystal Strategy I for his Tactical bucket, he has the potential to gain downside protection in volatile markets and the opportunity for appreciation in rising markets.
• Using Destinations Moderate for his Accumulation bucket, he has the potential to protect and grow purchasing power to sustain his standard of living in the future.

Once the first 24 months of the investment advisory relationship had passed, Rick understood how to view his portfolio through the prism of these three mental accounts. Our discussions on portfolio performance now takes place during periodic reviews and not during periods of volatility.

During the initial period of the investment advisory relationship with Rick, I had also begun to focus on the continued failure of the advice industry (investment managers, sponsors, broker-dealers and financial advisors) to apply the principles of behavioral finance in the investment advisory process. I soon realized that this was a key to more successful investing.

A Behavioral View of Finance

Through the efforts of noted scholars like Richard Thaler, Amos Tversky and Nobel Prize winner Daniel Kahneman, behavioral finance has established itself as a social science with a body of principles which are useful in predicting human behavior. During the last 20 years, many investment management firms have developed high quality presentations on behavioral finance. However, these firms neglected to develop investment offerings that integrate the principles of behavioral finance, even though individual investors continue to relate to their investment as human beings with behavioral biases, not just on the basis of return and risk (volatility).

For example, 30 years of data gathered by investment consulting firm Dalbar reveal that in periods of volatility, investors sell paper losses at bottoms and pile back in at market tops. This suggests that individual investors feel the pain of loss more than the pleasure of gain. As a result of this and numerous other behavioral tendencies or biases, actual investor performance materially underperformed commonly used indices for the 30-year period.

If, after the 2008-2009 Financial Crisis and Great Recession, former Federal Reserve Chairman Alan Greenspan (2014) can become "imbued with behavioral finance," why shouldn't the investment advice delivery system? If behavioral finance is good enough to be...