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Behaviorally Modified Asset Allocations for Independent Individualists

Independent Individualists can be difficult clients to advise because of their independent mindset, but they are usually grounded enough to listen to sound advice.

Michael M. Pompian, 04/15/2010

In the last article, we learned how to create a behaviorally modified asset allocations (also referred to as "best practical allocation") for a Friendly Follower behavioral investor type. We will now continue this learning process by examining the Independent Individualist. Our process will be to review the basics of the II and the biases at work with IIs, present a client scenario, and then discuss how to modify an asset allocation based on the behavioral characteristics of the II. In this exercise, we will not be examining standard-of-living risk. That concept will be incorporated in future articles.

Review of Independent Individualists
An Independent Individualist is an active investor with medium-to-high risk tolerance who is strong-willed and an independent-minded thinker. II's are self-assured and "trust their instincts" when making investment decisions; however, when they do research on their own, they may be susceptible to acting on information that is available to them rather than getting corroboration from other sources. Sometimes advisors find that an Independent Individualist client made an investment without consulting anyone. This approach can be problematic because, as a result of their independent mindset, these clients often irrationally cling to the views they had when they made an investment, even when market conditions change making advising II's challenging. They often enjoy investing, however, and are comfortable taking risks, but often resist following a rigid financial plan.

Some Independent Individualists are obsessed with trying to beat the market and may hold concentrated portfolios. Of all behavioral investor types, II's are the most likely to be contrarian, which can benefit them--and lead them to continue their contrarian practices. Independent Individualist biases are cognitive: conservatism, availability, confirmation, representativeness, and self-attribution.

Suppose you are beginning an engagement with a new client, Leo. You give him a standard risk tolerance quiz and determine that he is a growth-oriented risk tolerant investor. After that, you give him a test for behavioral biases of moderate clients. Based on the answers to the bias questions you determine that Leo is an II. Some of your other clients are growth-oriented in their risk tolerance but they are not biased like Leo. The object of this exercise is to see how to create a BMAA for an II versus a nonbiased or mildly biased growth investor. Generally, this can mean that an II should accept less risk in his portfolio than those clients without bias. Since Leo is an Independent Individualist, he may want to make investments in his portfolio outside of a recommended plan which may change the risk level in his overall portfolio without him realizing it. This makes working with an II somewhat more challenging than with some other BITs.

The following analysis presents two investment programs, one for Jack (a nonbiased growth investor) and one for Leo (an II). You are using Jack's portfolio allocation as a baseline for creating Leo's. Your basic task as to assess a retirement goal for Leo and the risk associated with the return needed to reach that goal. When working with actual clients, you will need to adjust this analysis to suit your purposes.

Independent Individualist (Leo) versus non-biased Growth Investor (Jack)

As we know, II clients are driven by cognitive biases and may make investments outside of a recommended plan

For Leo, an II, we are going to make an assumption that she may have difficulty sticking to a portfolio with a probability of a loss year at greater than 35%. For Jack, a nonbiased growth client, 35% may be just fine.

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