A simple way to modify a client's portfolio to account for their behavior and lifestyle.
In the last four articles we reviewed the concept of standard of living risk and discussed its implications for each behavioral investor type. We learned that to advise clients properly, financial advisors should assess the financial responsibilities of their clients and determine if clients have ample assets to cover these responsibilities. And once this is done, the advisor should create an appropriate asset allocation to match these responsibilities; often advisors recommend an investment program to a client based only on the output of a risk tolerance questionnaire but one element that is rarely captured in a risk tolerance questionnaire is the idea of how risky a person's lifestyle is in relations to their investment portfolio. In those articles, we also reviewed how one can modify an asset allocation to account for a client's SLR. You should now have a solid foundation of knowledge from which to understand the risks your clients face regarding their financial responsibilities and how to adjust a portfolio allocation to account for these responsibilities.
For the next six articles, we are going to build on the idea of modifying a client's portfolio allocation to account for their SLR and incorporate another key aspect of a person's financial lives: the types of biases they display--either cognitive or emotional. The methodology presented will result in a relatively simple but effective way to modify a client's portfolio to account for their behavior and lifestyle. This methodology is used to create a client's best practical allocation.
Introduction to Best Practical Allocation
For today's financial advisor, private banker or generalist wealth management practitioner (hereafter "financial advisor"), creating viable and unique investment solutions in response to the array of financial situations and personalities clients present is the heart and soul of the job. Sometimes the job is easy: the client being advised appears rational in his or her approach--that is, he or she seems to understand the importance of asset allocation and has reasonable return expectations. For these clients, the typical method for arriving at an asset allocation is to administer a risk tolerance questionnaire and use financial planning software to create a mean-variance-optimized asset allocation program. At other times, financial advisors encounter irrational behaviors in their clients. Irrational clients do such things as overestimate their risk tolerance, are unrealistic in their return expectations, or generally behave in a way that makes advising them difficult because they are not grounded in rational investment principles and are resistant to learning them. Most advisors have no trouble in the former case, the easy clients. In the latter case, however, some advisors get frustrated and impatient when confronted with an irrational client. In these situations, risk tolerance questionnaires and mean-variance software is often ineffective.
Understanding and applying behavioral finance solutions can help clients to meet their financial goals. But many advisors are often vexed by their clients' decision-making process when it comes to allocating their investment portfolio. Why? In a common scenario, a client demands, in response to short-term market movements, such as what we witnessed in late 2008 and early 2009, and to the detriment of the long-term investment plan, that his or her asset allocation be changed. This kind of behavior is a lose-lose situation for both the advisor and the client. The client loses because their portfolio is likely to underperform when they stray from their asset allocation policy targets (witness those who "sold out" in March 2009 only to see the market rebound dramatically.) The advisor loses because he or she becomes ineffective and can even be blamed for the decision to change allocation even if it was the client's idea.
Foundations of Best Practical Allocation
Nobel prize-winner Daniel Kahneman and coauthor Mark Riepe, who have made significant contributions to behavioral finance, describe financial advising as "a prescriptive activity whose main objective should be to guide investors to make decisions that serves their best interest." Serving the best interest of the client may be the recommendation of an asset allocation that suits the client's natural psychological preferences--and may not be one that maximizes expected return for a given level of risk. More simply, a client's best practical allocation may be a slightly underperforming long-term allocation recommendation that the advisors believes that client can comfortably adhere to. Conversely, another client's best practical allocation may be one that goes against his or her natural psychological tendencies, but the client may be well-served to accept more risk than he or she might otherwise be comfortable with--to attain a higher return for that level of risk. Note here that allocation recommendations are still on the efficient frontier; they may move up or down it based on the client's behavioral makeup. Our goal as advisors should be to find the best practical allocation for each individual client.
Developing proper guidelines for incorporating biases in asset allocation decision involves answering central questions:
When should advisors attempt to moderate the way clients naturally behave to counteract the effects of behavioral biases so that they can "fit" a pre-determined asset allocation? (For the purposes of this article, we will call this moderating a client.)
When should advisors create asset allocations that adapt to clients' biases, so that clients can comfortably abide by their asset allocation decisions? (For the purposes of this article, we will call this adapting to a client.)
The decision to moderate or adapt an asset allocation to fit a clients biases and their SLR (For simplification we will use "level of wealth" to describe whether a person has an SLR--high level of wealth means no SLR while a low level of wealth means an SLR.) requires careful consideration which will be the subject of next month's article. In that one, two key guidelines will be delineated for taking investor biases and SLR into account to create a client's best practical allocation. Thus equipped, financial advisors may more easily and fruitfully apply the body of behavioral finance research to their benefit.
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.