This is the twelfth article in a series focusing on behavioral investor types, and it is intended to help advisers strengthen their relationships with their clients by helping them better understand financial personalities. Once advisors understand the various investor types at play, they can adjust their advisory approach for each type.
In last month’s article, we reviewed the case of Tony Highsmith, a young sales executive. By way of refresher, here are some of the salient points about the case:
- Tony Highsmith is a 29-year-old successful sales executive for a real estate company.
- He is single; relatively well off (comes from an upper-middle-class family, well educated); and lives a high-spending lifestyle. He owns an expensive condo in downtown Boston and enjoys a healthy social life.
- He saves 20% of his income to invest for the long run. His investment portfolio is 100% invested in stocks.
- Tony recently got engaged to Chloe, age 28, who works as a dental assistant. They plan on having a family in the next few years, and Chloe will stay home to take care of the family.
- Tony began investing in 2011. Since he has never been through a full market cycle, he assumes this one will continue, and he therefore continues to invest in risky stocks. He invests in index exchange-traded funds and technology stocks such as Apple (AAPL), Amazon.com (AMZN), Facebook (FB), Alphabet (GOOG), and Netflix (NFLX). He thinks that if he does not invest in these stocks, he will regret it later.
- Tony has managed to save and invest $250,000. His near-term goal is to buy a house in the Boston suburbs with his fiancée and contribute to the cost of their wedding. Longer-term, he wants to raise a family and retire at age 60.
- You have been working with Tony for the past two years. When you began working with him, he took a risk-tolerance questionnaire that indicated his portfolio should be about 65% equity and 35% bond/cash.
- Even though he is young and has a long-time horizon, his short-term goals of saving for the wedding and a down payment for a house in the suburbs indicate to you that he should have some bonds and cash.
- Tony wants to be in the investments that all his friends are in, buying risky tech stocks. In meetings, you have pointed out that in 2000, tech stocks were decimated, but this has not deterred him from investing 40% of his portfolio in five technology stocks. He has FOMO--the fear of missing out. You sense he is overestimating his risk tolerance.
- Tony is not receptive when you tell him you think he should diversify his portfolio. You are concerned that Tony hasn’t been through any adversity in his career and is being naïve about risk. You think that he could be setting himself up for failure in his short-term goal of saving for his wedding and house and, possibly, the important years of saving for college and meeting the longer-term goal of retiring early.
To better understand his situation, we are going to answer the following questions and then will provide a suggested solution to their situation.
1) What is his behavioral investor type?
2) What behavioral biases might drive his behavior and decision-making? What specific evidence leads you to this diagnosis?
3) How might Tony’s personal biases affect the asset-allocation decision?
4) How should the advisor approach the client to moderate or adapt the impact of these biases?
5) What is a reasonable allocation recommendation for Tony?
6) How should you as the advisor facilitate the client conversation so that the client makes a good and thoughtful investment decision and shows more consistent investor behavior?
Case Study: Answers to Questions
Tony’s biases are very consistent with a behavioral investor type. We know that he is a Follower because, based on the descriptions in the case study, he has the following biases:
Recency bias--A predisposition to recall and emphasize recent events and/or observations, and to extrapolate patterns where none exist.
Hindsight bias--Occurs when an investor perceives past investment outcomes as having been predictable.
Framing bias--The tendency of investors to respond to situations differently on the basis of the context in which a choice is presented (framed).
Cognitive Dissonance bias--Occurs when people believe something and persist in believing it--even when faced with evidence to the contrary--because they don’t want to acknowledge the discomfort of their beliefs being wrong.
Regret Aversion Bias--Avoiding taking decisive actions because of the fear that an investor might, in hindsight, regret whatever course he or she selects.
The Follower behavioral investor type leads investors to move toward risk even when they don’t have the risk tolerance to accept excessive risk. This is the case here, because Tony wants to be in the latest fad investments (FAANG); he is ignoring the risks. Tony’s recency bias (thinking that prosperity will last indefinitely) coupled with regret aversion (thinking he will regret not owning FAANG stocks) have caused him to be more risk-tolerant than he should be. In addition, he has cognitive dissonance bias, because he won’t accept the fact that there have been periods when tech stocks have done poorly.
It is up to you now to decide how to prepare a recommendation for Tony. You have been working with Tony for two years and your first recommendation for him was an asset allocation of 65% equities, 25% bonds, and 10% cash. He chose a more-aggressive allocation of 100% equities and no bonds or cash. You decide to meet him near the middle, suggesting an allocation that incorporates his financial goals while at the same time accounting for his biases. Therefore, you decide that a reasonable allocation is 75% equity, 10% cash, and 15% bonds. You call Tony to schedule a meeting to go over your recommendations. When you have the meeting, you decide that you will accomplish the following as it relates to explaining your recommendations and his reactions to them.
- Listen--Seek to understand. Listen actively.
- Clarify--Confirm your understanding of his desires and ask clarifying questions to go deeper.
- Empathize--Summarize your understanding and demonstrate that you see his perspective. If appropriate, acknowledge his feelings about the topic.
- Explore--Rationally explore the alternatives to consider.
- Answer--When you make your recommendation, explain why it is the rational choice. Connect the recommendation to the vision of the goal by inviting the client to “imagine” what success will feel like.
- Check--Check for agreement.
This post by Michael M. Pompian first appeared on Morningstar.com
Michael M. Pompian, CFA, CAIA, CFP is an investment consultant to ultra-affluent clients and family offices, and is based in St. Louis. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients. Contact him at michael@sunpointeinvestments.com.