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Behavior Survey: Moderate Investors With Advisors

More results from our attempt to connect real people with behavioral finance theory.

Michael M. Pompian, 01/20/2011

We have been reviewing the results a survey that I created in February 2010 that was completed by 980 individual investors who subscribe to either Morninstar.com and/or Morningstar investor newsletter publications. The purpose of the survey was to gauge investing behavior and choices and how influential these choices are in the investment decision-making process. The survey was also done to learn more about the four behavioral investor types that I developed (that we have been reviewing over the past two and a half years) and how financial advisors can be better prepared to work with them. Of the 980 surveys that were completed, 308 were completed by investors who use financial advisors. Here we will be reviewing answers to bias questions of investors using financial advisors. This information can be highly relevant to advisors in their quest to serve clients in the best way possible. It is important to remember that the Morningstar investor survey is composed of a very specific type of investor population so let's review that now. (More details on the survey can be found in the original article.)

The population of survey takers in the Morningstar universe was generally defined as "mostly male, mostly experienced (experienced having a double meaning here--experienced in the sense that they are not new to investing and experienced in the sense that that over half of the survey takers were over 60 years old), and mostly do-it-yourself" investors. What this means is that the majority of survey takers were proactive, engaged and self-directed investors which, naturally, is only a subset of all investors. The populations of survey takers that use financial advisors are likely to be somewhat less self-directed but we can assume since they subscribe to Morningstar services, they are still somewhat self-directed. It is important to remember not to extrapolate what is learned in this set of articles to the general population of investors because it contains many passive and/or unsophisticated investors as well as "middle of the road" investors who are somewhat engaged but don't have the time or aptitude for more. And of course, the general population of investors contains a higher percentage of women and young investors. For simplicity, I will call the investors who took the survey that use financial advisors "PEM-FA investors" going forward to stand for Proactive, Experienced and Male investors who use financial advisors. We will now review the biases of moderate investors.

Recency Bias
Bias Type: Cognitive
Bias description: Recency bias is a predisposition for investors to recall and emphasize recent events and/or observations. They may extrapolate patterns where none exist. Some of these investors enter or hold on to investments when prices are peaking, which can end badly, with sharp price declines. Below is the survey question related to Recency bias.
(View the related graphic here.)
Commentary: With nearly two-thirds of investors answering this question in the affirmative, this is not quite what I would have expected from those respondents working with FAs. Regardless of the type of investor, everyone has bought into an overvalued market or overvalued investment--because it is simply human nature to want to "get in" to a rising sector during a bull market. But there are perils. Those who entered the housing market in 2007 for example either through direct real estate purchases or real estate stocks know how recency bias can be harmful. But I would have expected a lower number of respondents to have answered yes. This is an opportunity for advisors to counsel their clients!

Hindsight Bias
Bias Type: Cognitive
Bias Description: Moderate clients often lack independent thought about their investments and are susceptible to hindsight bias which occurs when an investor perceives investment outcomes as if they were predictable. The result of hindsight bias is that it gives investors a false sense of security when making investment decisions, emboldening them to take excessive risk without recognizing it. Below is the survey question related to hindsight bias.
(View the related graphic here.)
Commentary: I'm glad to see that at least 50% of the survey takers realize that investment outcomes are not predictable although I would have expected a higher number from those who work with FAs. In the end, investing is a probabilistic endeavor and those who believe that investment outcomes can be predicted need to reevaluate their thinking. The significance of this chart is high. Advisors need to manage the expectations of their clients in terms of how predictable their client's portfolios will perform from one year to the next, and even from one decade to the next. Would you have believed it if I told you in 2000 that the return on the S&P 500 would be approximately zero by the end of 2009?

Framing Bias
Bias Type: Cognitive
Bias Description: Framing bias is the tendency of investors to respond to situations differently based on the context in which a choice is presented (framed). Often, moderate investors focus too restrictively on one or two aspects of a situation, excluding other considerations. Below is the survey question related to framing bias.
(View the related graphic here.)
Commentary: This was actually somewhat of a trick question. Statistically speaking a three standard deviation event should happen approximately one in 100 years not one in 10 years . . . but perhaps because we've had such wild swings in market valuations over the past 10 years, investors are getting used to these events. In any case I was very impressed to see that such a high percentage of respondents who work with FAs said they would stick to their plan.

Cognitive Dissonance Bias
Bias Type: Cognitive
Bias Description: In psychology, cognitions represent attitudes, emotions, beliefs or values. When multiple cognitions intersect - for example a person believing in something only to find out it is not true--people try to alleviate their discomfort by ignoring the truth and/or rationalizing their decisions. Investors who suffer from this bias may continue to invest in a security or fund they already own after it has gone down (average down) even when they know they should be judging the new investment with objectivity. Below is the survey question related to this bias.
(View the related graphic here.)
Commentary: Given that such a high number of respondents chose the first answer, it's possible that this question could have been interpreted in a different way than intended based on the bias description. Even so, since such a high number of respondents answered that they would buy more because it's cheaper is a yellow flag. And you know why. Just because something is cheap doesn't mean it's a good investment. Advisors need to be aware of their clients' tendency to want to buy cheaper when they have some familiarity with an investment.

Ambiguity Aversion Bias
Bias Type: Cognitive
Bias Description: Ambiguity aversion is a difficult bias to explain; therefore an example works best. Suppose a researcher asks you your prediction as to the outcome of an ambiguous situation: whether a certain sports team will win its upcoming game. Suppose the estimate given is 60% that the team wins. Further suppose the researcher presents you with a 50%/50% slot machine, which offers no ambiguity, and then asks which bet is preferable. If you are ambiguity-averse, you will likely choose the slot machine, even if you feel confident about the team winning. Below is the survey question related to ambiguity aversion bias.
(View the related graphic here.)
Commentary: There are some potential negatives and some potential positives associated with this response. One the negative side, what this chart tells me is that when PEM investors who work with FAs feel confident about or emotional (such as their favorite sports team) about something they will "go for it" which is a red flag for advisors. If a client has an affinity for an investment or feels confident about it and they "go for it" this can be a losing strategy. On the positive side, this tells me that PEM investors who work with FAs have a tolerance for ambiguity which is good when it comes to investing in securities or funds that exhibit volatility. This makes the job of the advisor easier. Advisors should probe clients on this issue to see how they may respond to situations like this.

Hopefully you have learned something about how PEM investors who work with FAs are biased and how you might begin to think about counseling them when you encounter these biases. Next month we will be reviewing how PEM investors who work with FAs answered questions related to biases growth-oriented investors.

Michael M. Pompian, CFA, 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.


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