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The 2010 Behavioral Alpha/Morningstar Survey

Here's our attempt to connect behavioral finance theory with real investors.

Michael M. Pompian, 06/17/2010

Today marks my two-year anniversary writing articles for Morningstar. To celebrate, we will be taking a break from learning about creating behaviorally modified portfolios and begin a series of articles examining the results of a practical application of behavioral finance survey conducted in partnership with MorningstarAdvisor.com. In February 2010, The survey was completed by 980 individual investors who subscribe to either Morningstar.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 Alpha investor types that I have developed (which we have been reviewing over the past two years) and how financial advisors can be better prepared to work with them.

At the outset, I was hopeful that doing the survey would be an opportunity to learn about a "general population" of investors; that is, we could draw widely applicable conclusions about answers to bias questions and identify behavioral investor types easily and, thus, be able to offer broad advice about what was learned. Once the survey results came in, it was clear that we were dealing with a very specific type of investor population.

About the Survey-Takers
The population of survey takers in the Morningstar universe can be generally defined as "mostly male, mostly experienced (experienced in the sense that they are not new to investing and experienced in the sense that that more than half of the survey takers were older than 60), and mostly do-it-yourself" investors. The majority of survey-takers were very proactive, engaged, and self-directed investors, which, naturally, is only a subset of all investors. It is therefore important that readers not extrapolate what they learn in this set of articles to their entire client base, because the general population of investors 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 "PEM investors" going forward to stand for proactive, experienced, and male investors. A statistical description of the survey-takers can be seen in the chart below. It should be noted that approximately a third of all survey-takers identified themselves as working with financial advisors.

(View the related graphic here.)

(View the related graphic here.)

(View the related graphic here.)

Understanding Behavioral Biases of "Proctive, Experienced, and Male" Investors
As many readers know, the building blocks of behavioral investor types are the 20 behavioral biases I outline in my book, Behavioral Finance and Wealth Management. It will be incredibly insightful for us to examine how prevalent each bias is within the population of PEM investors. As advisors, we tend to think of investors more than 60 years old as those that should have a somewhat risk-averse posture toward their portfolios. Put differently, conventional wisdom suggests that more-risk-tolerant investors tend to have longer time horizons, meaning they are likely younger. The survey-takers are fairly risk-tolerant investors who are in the later stages of their lives.

In the context of what we have learned about behavioral investor types, active investors (Independent Individualists and Active Accumulators), whom we typically think of as younger investors, have a strong proclivity toward certain biases. So it will be interesting to see if these biases resonate with PEM investors. With medical technology and information aplenty about living longer, it could be argued that 60-year-olds have a 30-year-plus time horizon--so perhaps this population is thinking in a new way that isn't in sync with the average advisor. Lastly, we need to also recognize that even risk-tolerant investors, regardless of age, will have biases associated with conservative investors. Human behavioral study cannot be made equivalent to other sciences like chemistry, where it is know exactly what is taking place (H2O will always make water, for example.)

In next month's article, we will be reviewing how PEM investors answered questions related to biases of passive, low-risk-tolerant investors (Passive Preservers.) How many of you can remember what those are?

Loss-Aversion Bias
Bias Type: Emotional
PPs tend to feel the pain of losses more than the pleasure of gains as compared to other client types. As such, these clients may hold only losing investments too long--even when they see no prospect of a turnaround. Loss aversion is a very common bias and is seen by large numbers of financial advisors.

Status Quo Bias
Bias Type: Emotional
PPs often prefer to keep their investments (and other parts of their life for that matter) the same or keep the "status quo." These investors tell themselves "things have always been this way" and thus feel safe keeping things the same.

Endowment Bias
Bias Type: Emotional
PPs, especially those that inherit wealth, tend to assign a greater value to an investment they already own (such as a piece of real estate or an inherited stock position) than they would if they don't possess that investment and had the potential to acquire it.

Regret-Aversion Bias
Bias Type: Emotional
PPs often avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Regret aversion can cause some investors to be too timid in their investment choices because of losses they have suffered in the past.
 
Anchoring Bias
Bias Type: Cognitive
Investors in general, and PPs in particular, are often influenced by purchase points or arbitrary price levels, and tend to cling to these numbers when facing questions like "should I buy or sell this investment?" Suppose that the stock is down 25% from its high that it reached five months ago ($75/share vs. $100/share). Frequently, a PP client will resist selling until its price rebounds to the $100/share it achieved five months ago.

Mental Accounting Bias
Bias Type: Cognitive
Many investors treat various sums of money differently based on where these sums are mentally categorized. For example, PPs often segregate their assets into safe "buckets." If all of these assets are viewed as safe money, sub-optimal overall portfolio returns are usually the result.
Enjoy the beginning of summer!

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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