Behavioral Finance and Wealth Management

Pompian wrote this as a practical guide for financial advisers on identifying clients' behavioural biases and adjusting portfolio recommendations accordingly.

The structure has two parts. The first catalogues twenty biases, dividing them into cognitive errors, meaning faulty reasoning that can be corrected with information and education, and emotional biases, meaning feelings that resist correction and must be accommodated. Cognitive errors include overconfidence, representativeness, anchoring, availability, conservatism, confirmation, hindsight, mental accounting, framing and illusion of control. Emotional biases include loss aversion, regret aversion, status quo bias, endowment and affinity.

The practical framework follows from this distinction. Pompian argues that cognitive errors should be corrected through education and process, while emotional biases should generally be accommodated in the portfolio, because attempting to correct them produces a portfolio the client will abandon at the worst moment. The decision about whether to moderate or adapt depends on the client's wealth level relative to their needs and on the strength of the bias: a wealthy client whose lifestyle is secure can be adapted to, while a client whose plan depends on returns must be moderated.

He also presents behavioural investor types as a diagnostic framework for classifying clients, and a set of questions for identifying which biases a particular client exhibits.

The book is written for practitioners rather than researchers and does not test its own framework. The bias taxonomy is drawn from the academic literature, and some of the underlying studies have been affected by replication problems. The practical argument, that an adviser should build a portfolio a client will actually hold rather than the theoretically optimal one, is sound and is the book's main contribution.