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Assessing Standard-of-Living Risk of Friendly Followers

Friendly Followers want to be in the latest, most popular investments without regard to a long-term plan.

Michael M. Pompian, 09/17/2009

Last month's article reviewed the basics of assessing standard-of-living risk, or SLR, for Passive Preservers. Advisors often will recommend an investment program to a client based purely on their risk tolerance questionnaire. One element that is rarely captured in a risk tolerance questionnaire (or anywhere else, for that matter) is the idea of how risky a person's lifestyle is in relation to his investment portfolio. 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 an appropriate asset allocation to match. The next behavioral investor type we will examine is the Friendly Follower. Our process is to review the basics of each BIT, discuss the effects of SLR on that behavioral investor type and then review an example of how we might modify the details of an investment program for each behavioral investor type, with and without an SLR.

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- Friendly Followers 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 Friendly Follower client, Juan. You give him a standard-of-living-risk questionnaire after having tested for behavioral biases of conservative clients and a standard risk-tolerance quiz. Based on the answers to the SLR he has been identified 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 or other adversity based on his current lifestyle. Generally, this can mean that he should accept less risk in his portfolio than those clients without a standard of living risk. Since he is a Friendly Follower, he might overstate his risk tolerance. This makes working with Friendly Follower clients with an SLR more challenging than with some other BITs.

The following analysis presents two investment programs, one for Juan (with an SLR) and one for his brother Enrique (without an SLR). Enrique's investment program is based primarily on answers to a risk-tolerance questionnaire and his behavioral biases but not on SLR since he does not have one. You are using Enrique's portfolio allocation as a baseline for creating Juan's. 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.

Friendly Follower BIT With and Without an SLR
As we know, Friendly Follower clients:
* Have primarily cognitive biases
* Don't have their own ideas about investing
* Are prone to overestimating their risk tolerance

For Juan, a Friendly Follower with an SLR, we are going to make an assumption that he may have difficulty sticking to a portfolio with a probability of a loss year at greater than 20%. For Enrique, a PP client without an SLR, 20% may be too conservative and can be higher. The following table summarized investment programs for both Juan and Enrique.

FFriendly Follower BIT With an SLR (Juan)

Friendly Follower BIT Without an SLR (Enrique)

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