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Behaviorally Modified Asset Allocations for Friendly Followers

One of the key challenges of working with Friendly Followers is that they often overestimate their risk tolerance.

Michael M. Pompian, 03/18/2010

In the last article, we learned how to create a behaviorally modified asset allocations or BMAA (also referred to as best practical allocation) for a Passive Preserver behavioral investor type. We will now continue this learning process by examining the Friendly Follower. Our process will be to review the basics of the FF and the biases at work with FFs, present a client scenario, and then discuss how to modify an asset allocation based on the behavioral characteristics of the FF. Note that in this exercise we will not be examining standard of living risk. We will tie that concept in later in subsequent articles.

Review of Friendly Followers
Friendly Followers are passive investors who usually do not have their own ideas about investing. They often follow the lead of their friends and colleagues in investment decisions, and want to be in the latest, most popular investments without regard to a long-term plan. One of the key challenges of working with Friendly Followers is that they often overestimate their risk tolerance. Advisors need to be careful not to suggest too many "hot" investment ideas--FFs will likely want to do all of them. Some don't like, or even fear, the task of investing, and many put off making investment decisions without professional advice; the result is that they maintain, often by default, high cash balances. Friendly Followers generally comply with professional advice when they get it, and they educate themselves financially, but can at times be difficult because they don't enjoy or have an aptitude for the investment process. Biases of Friendly Followers are cognitive: recency, hindsight, framing, cognitive dissonance, and ambiguity aversion.

Scenario
Suppose you are beginning an engagement with a new client, Amy. You give her a standard risk-tolerance quiz and determine that she is a moderately risk-tolerant investor. After that, you give her a test for behavioral biases of moderate clients. Based on the answers to the bias questions you determine that Amy is an FF. Some of your other clients are moderate in their risk tolerance but they are not biased like Amy. The object of this exercise is to see how to create a BMAA for an FF versus a nonbiased or mildly biased moderate investor. Generally, this can mean that an FF should accept less risk in her portfolio than those clients without bias. Since Amy is a Friendly Follower, she might overstate her risk tolerance. This makes working with an FF somewhat more challenging than with some other BITs.

The following analysis presents two investment programs, one for Bill (a nonbiased moderate investor) and one for Amy (a FF). You are using Bill's portfolio allocation as a baseline for creating Amy's. Your basic task as to assess a retirement goal for Amy 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.

Friendly Follower (Amy) versus non-biased Moderate Investor (Bill)
As we know, FF clients:
* are driven by cognitive biases;
* tend to overestimate their risk tolerance.

For Amy, a FF, 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 25%. For Bill, a moderate client, 25% may be too conservative and can be a bit higher.


Advice for Friendly Followers
Advisors to Friendly Followers first and foremost need to recognize that FFs often overestimate their risk tolerance. Risky trend-following behavior occurs in part because FFs don't like situations of ambiguity that may accompany the decision to enter an asset class when it is out of favor. They also may convince themselves that they "knew it all along" when an investment idea goes their way, which also increases future risk-taking behavior. Advisors need to handle Friendly Followers with care because they are likely to "say yes" to investment ideas that make sense to them regardless of whether the advice is in their best long-term interest. Advisors need to lead FFs to take a hard look at behavioral tendencies that may cause them to overestimate their risk tolerance. Because Friendly Follower biases are mainly cognitive, education on the benefits of portfolio diversification and sticking to a long-term plan is usually the best course of action. Advisors should challenge Friendly Follower clients to be introspective and provide data-backed substantiation for recommendations. Offering education in clear, unambiguous ways so they have the chance to "get it" is a good idea. If advisors take the time, this steady, educational approach will generate client loyalty and adherence to long-term investment plans.

Next month we will learn how to create a BMAA for Independent Individualists.

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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