The line between recent “exotic preferences” and “behavioral finance” is so blurred that it describes academic politics better than anything substantive.
– John Cochrane University of Chicago
John Cochrane, as well as others in finance, has focused on the academic issue of defining preferences for investors at an abstract level, but the issue becomes a reality when trying to extract preferences from investors to help build a portfolios.
Recently working with some institutional investors, the greatest amount of time was spent not picking the strategy or portfolio elements but defining their preferences. How much upside did they want? How much downside were they willing to take? What is the chance of a tail risk event and how much protection did they want for these rare events? How are their performance preferences measured, holistically, by sector, or by market? How much regret are they willing to suffer from tracking error versus benchmarks? This list could go on.
Many investors have an intuitive feel for what they want from their portfolio but the exercise of asking for precision in their preferences is very useful. Is it a behavior bias to have more regret or disutility for loses over gains? Is it wrong to focus on recent performance or tracking error on an individual manager? Is the concern about “poor” performance from negative or low correlated assets to equities when stocks go up justified? This are real issues that need to be discussed with investors.
These preference orderings are not academic questions but the core for understanding investor needs, asset allocation, and recommendations for portfolio construction.