CASE B: MR. BOULDER Mr. Boulder (hereafter Mr. B) is a single 50-year-old, hard-charging pharmaceutical executive earning $250,000 per year. He lives extravagantly and occasionally overspends, but he has saved approximately $1.5 million. Mr. B had a mild heart attack last year but now has a clean bill of health. His primary financial goal is to retire comfortably at 65 and to donate $3 million to his alma mater (he cannot obtain adequate life insurance to cover the gift). You have been working with Mr. Boulder for less than a year. Youve drafted a financial plan but have yet to modify Mr. Bs preexisting allocation (nearly 100 percent equities). However, you have developed a good working relationship with Mr. B, who listens intently and seems receptive to your recommendations. You believe that Mr. Boulder is a wellgrounded person and is self-aware, but you also believe that he has some behavioral issues to deal with. Analysis At the outset of your relationship, you outlined a more conservative, mean-variance optimized allocation (see Table 24.2) as an objective in Mr. Bs financial plan; however, you are worried that Mr. B may not fully buy into the idea. Your concern is that a severe downward market fluctuation may cut into Mr. Bs daily living expenses, including possible 262 CASE STUDIES TABLE 24.2 Behavioral Asset Allocation Adjustment Factor Model Output for Mr. Boulder Mean- Behaviorally Change in Change in Variance Adjusted Percent Percent Output Allocation (Absolute (Weighted Recommendation Recommendation Variance Value) Value) Equities 70 75 5 7% 5% Fixed income 25 15 10 40% 10% Cash 5 10 5 100% 5% 100 100 Bias Adjustment Factor = 20% Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, March 2005, Pompian and Longo, Incorporating Behavioral Finance into Your Practice. For more information on the Financial Planning Association, please visit www.fpanet.org or call 1-800-322-4237. health expenses. Your financial planning software tells you that with a less aggressive portfolio, Mr. B can still meet his primary financial objectives. However, Mr. B thinks that he is a very good investor, and you are worried that such a change might cause him to regret not being more aggressive. He agrees to complete a comprehensive behavioral bias questionnaire, and his results show susceptibility to: Overconfidence bias (the tendency to overestimate ones investment savvy). Regret aversion bias (the tendency to avoid making a decision for fear that the decision may cause regret later on). Self-control bias (the tendency to spend today rather than save for tomorrow). The mean-variance optimized allocation you initially calculated for Mr. B was 70 percent stocks, 25 percent bonds, 5 percent cashMr. Bs risk tolerance better suits a more balanced portfolio. You also have obtained confirmation of the specific behavioral biases that are probably causing the distortion in Mr. Bs portfolio. Your job is now to answer these questions: 1. What effect do Mr. Bs biases have on the asset allocation decision? 2. Should you moderate or adapt to his biases? 3. What is the best practical allocation for Mr. B?