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Best Practical Allocation (Part Two)

When to maintain a rational asset allocation and when to give in to behavioral biases.

Michael M. Pompian, 01/21/2010

In the financial advisory field today, there are some advisors who are on the cutting edge of their practice, and have accepted the challenge of working with irrational clients by taking the initiative to learn the psychology behind irrational financial decision-making--behavioral finance. As we learned in the last article, in order to develop proper guidelines for applying biases to asset allocation decisions, advisors must answer a central question: When should I, as the advisor, attempt to change the way my client is behaving (to counteract the effects of behavioral biases), because I believe that the "rational" asset allocation that my financial planning software has created is the best one for him or her (for purposes of this paper we will call this moderating a client)? And when should I, as the advisor, change the rational asset allocation that I would normally suggest for a client because I believe that unless I modify it, the client's irrational behavior will cause the client make investment mistakes in the future--for example, to change the asset allocation at the wrong time to his or her detriment (the client will be unable to comfortably "stick" to the allocation I might suggest and change it at just the wrong time, jeopardizing reaching his or her long-term financial goals). For purposes of this report we will call this adapting to a client.

When to Moderate and When to Adapt 
Here are two guidelines that financial advisors can use when deciding when to attempt to moderate the behavior of their clients to meet the "rational" asset allocation that was created by the advisor or when to change a "rational" asset allocation the advisor would otherwise recommend in order to adapt to a client's behavioral biases.

Guideline 1: The financial advisors decision whether to moderate or adapt to a client's behavioral biases during asset allocation depends in large part on the client's wealth level. Specifically, the wealthier the client, the more the advisor is safely able to adapt the asset allocation to the client's behavioral biases. The less wealthy the client is, the more the advisor should attempt to moderate a client's biased behavior to match a rational asset allocation.

The rationale for this guideline has to do with a concept we learned in earlier articles--"standard of living" risk. If a client is at risk for outliving his or her assets or seriously jeopardizing his or her standard of living based on their current asset allocation, this is a major problem that needs to be carefully considered by the advisor. No advisor wants to be responsible for causing a client to become destitute, naturally. If biased behavior, then, is likely to endanger a client's standard of living, regulating the client's behavior is likely to be the best course of action. This can be the case for both too conservative and too risky allocations. On the other hand if a client bears no standard of living risk (that is, the client's standard of living is highly unlikely to be jeopardized and will remain in the 99.9th percentile save a market crash of unprecedented proportions) irrational biases become a lesser consideration, and adapting the rational allocation to the clients irrational behavior may be the more appropriate action. In other words, destitution constitutes a far graver investment failure than a client's inability to amass the greatest possible fortune.

Guideline 2: The financial advisor's decision whether to moderate or adapt to a client's behavioral biases during the asset allocation process also depends fundamentally on the type of behavioral biases being exhibited by the client. Specifically, clients exhibiting cognitive biases, which stem from illogical reasoning, should be moderated, while those clients exhibiting emotional biases, which stem from impulsive feelings, should be adapted to.

The rationale for Guideline 2 is straightforward. As we have learned, behavioral biases fall into two broad categories, cognitive and emotional, though both types yield irrational decisions. Because cognitive biases stem from illogical reasoning, better information and advice can often correct them. Conversely, because emotional biases originate from impulsive feelings or intuition--rather than conscious reasoning--they are difficult to correct. Financial advisors need to understand this difference, because if they attempt to correct biases that they have little chance of correcting, they will become frustrated and ineffective. Cognitive biases include heuristics, such as anchoring and adjustment, availability, and representativeness biases. Other cognitive biases include selective memory and overconfidence. Emotional biases include regret, self-control, loss-aversion, hindsight, and denial. We have discussed these biases in earlier articles.
For advisors who encounter less-wealthy clients exhibiting cognitive biases, the best course of action is typically to attempt to change the behavior of the client to meet the rational asset allocation that the advisor might normally recommend. For clients exhibiting emotional biases at higher levels of wealth, advisors should modify the rational asset-allocation recommendation and adapt to the client's behavioral biases.

For clients at low levels of wealth who exhibit emotional biases, and for clients at high levels of wealth who exhibit cognitive biases, advisors should offer a blended recommendation. How might this blended recommendation be accomplished? The short answer is that a client's asset allocation may not change as much, for example, for a higher-wealth client exhibiting emotional biases as when adapting to a higher-wealth client who exhibits cognitive biases. In the case of a less-wealthy client with strong emotional biases, the advisor might modify a client's asset allocation decision modestly rather than recommending the rational asset allocation as an advisor would for a less-wealthy person exhibiting cognitive biases. The following table summarizes the adapt and moderate actions advisors can take with their clients.

Adapt and Moderate Recommendations
                                  Cognitive Bias                                                             Emotional Bias
High Wealth Level         Modest Asset Allocation Change                                    Stronger Change
Low Wealth Level          Typically Recommend Rational Asset Allocation              Modest Change

Next month  we will review the best practical allocation for the Passive Preserver client type.

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