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Assessing Standard-of-Living Risk of Independent Individualists

Independent Individualists need your help to work through standard-of-living-risk challenges.

Michael M. Pompian, 10/15/2009

Last month, we reviewed the basics of assessing standard-of-living risk for Friendly Followers. Often, advisors will recommend an investment program to a client based purely on their risk tolerance questionnaire. One element that is rarely captured in a questionnaire (or anywhere else, for that matter) is the idea of how risky a person's lifestyle is in relations to their investment portfolio. To advise clients properly, advisors should assess the financial responsibilities of their clients and determine whether clients have ample assets to cover these responsibilities and an appropriate asset allocation to match. 

The next behavioral investor type that we will examine is the Independent Individualist.

Review: Independent Individualists
An Independent Individualists are active investors with medium-to-high risk tolerance who are strong-willed and independently-minded thinkers. They 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, Independent Individualists make an investment without consulting anyone. This approach can be problematic because, due to their independent mindset, these clients often irrationally cling to the views they had when they made an investment, even when market conditions change. This makes advising Independent Individualists 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, Independent Individualists 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.

Scenario
Suppose you are beginning an engagement with Boris, an Independent Individualist. You give him a standard-of-living risk questionnaire after having tested him for behavioral biases of growth-oriented clients and a standard risk tolerance quiz. Based on his answers to the standard-of-living questionnaire, you identify him as someone with a standard-of-living risk. This means that he may not have an extra cushion of money available to him to withstand a "shock to the system," such as a job loss, disability, and other potential adversities based on current lifestyle. Generally, this can mean that he should accept less risk in his portfolio than those clients without a standard of living risk.

Because he is an Independent Individualist, he is likely to recognize that he needs your help to work through this challenge.

The following analysis presents two investment programs, one for Boris (with a standard-of-living risk) and one for his sister Natasha (without a standard-of-living risk). Natasha's investment program is based primarily on answers to a risk-tolerance questionnaire and her behavioral biases. You are using Natasha's portfolio allocation as a baseline for creating Boris'. Your basic task as to assess a retirement goal for your client and the associated return needed to reach that goal. When working with actual clients, you will need to adjust this analysis to suit your purposes.

Independent Individualist with and without a Standard-of-Living Risk
As we know, Independent Individualist clients:

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