Aggressive clients are the most difficult clients to advise, particularly those who have experienced losses.
Last month's column reviewed the third of the four behavioral investor types, the Independent Individualist. This month is a look at the last BIT, the Active Accumulator. If you recall, behavioral investor types are the foundation of the Behavioral Alpha system I developed to more easily apply behavioral finance in practice, and it's based on more than a decade of research. Behavioral Alpha builds on key concepts I outlined some of my early papers as well as my book Behavioral Finance and Wealth Management.
As we discussed in the last article, the least-risk-tolerant BIT and the most-risk-tolerant BIT clients are emotionally biased in their behavior. In the middle of the risk scale are BITs that are affected mainly by cognitive biases. This should make intuitive sense. Clients who have a high need for security (a low risk tolerance) do so because emotion is driving this behavior; they get emotional about losing money and get uneasy during times of stress or change. Similarly, highly aggressive investors are also emotionally charged people. They typically suffer from a high level of overconfidence and mistakenly believe that they can control the outcomes of their investments. In between these extremes are the investors who suffer mainly from cognitive biases and can benefit from education and information about their biases so they can make better investment decisions. With aggressive clients, the best approach is to deal with their biases head-on and discuss how their investment decisions will affect emotional issues such as family members, their legacy or lifestyle.
With Active Accumulators, we continue within the realm of the active investor. As we reviewed in earlier articles, active investors have been involved in their own wealth creation, typically risking their capital in achieving their wealth objectives. Active investors have a higher tolerance for risk than they have need for security. Their tolerance for risk is high because they believe in themselves. Related to their high risk tolerance is the fact that active investors prefer to get very involved in investment decision making and aren't afraid to roll up their sleeves and do due diligence on contemplated investments. Let's turn our attention now to the last of the two active behavioral investor types, the Active Accumulator.
Basic type: Active
Risk tolerance: High
Primary Bias: Emotional and Cognitive
The Active Accumulator is the most aggressive behavioral investor type. These clients are entrepreneurial and often the first generation to create wealth, and they are even more strong-willed and confident than Independent Individualists. At high wealth levels, Active Accumulators often have controlled the outcomes of non-investment activities and believe that they can do the same with investing. This behavior can lead to overconfidence in investing activities. Left unadvised, Active Accumulators often trade too much, which can be a drag on investment performance. Active Accumulators are quick decision-makers but might chase higher-risk investments. Some Active Accumulators can be difficult to advise because they don't believe in basic investment principles such as diversification and asset allocation. They are often "hands-on," wanting to be heavily involved in the investment decision-making process. Biases of Active Accumulators are overconfidence, self-control, optimism, and illusion of control.
Biases of Active Accumulators
Bias Type: Emotional
Overconfidence is best described as unwarranted faith in one's own thoughts and abilities - which contains both cognitive and emotional elements. Overconfidence manifests itself in investors' overestimation of the quality of their judgment. Many Active Accumulators claim an above-average aptitude for selecting stocks; however numerous studies have shown this to be a fallacy. For example, a study done by researchers Odean and Barber showed that after trading costs (but before taxes), the average investor underperformed the market by approximately 2% per year due to unwarranted belief in their ability to assess the correct value of investment securities.
Bias Type: Emotional
Self-control bias is the tendency to consume today at the expense of saving for tomorrow. The primary concern for advisors with this bias is a client with high risk tolerance coupled with high spending. For example, suppose you have an Active Accumulator client who prefers high-volatility investments and has high current spending needs and suddenly the financial markets hit severe turbulence. This client might be forced to sell solid long-term investments that have had been priced down because of current market conditions just to meet current expenses.
Bias Type: Emotional
Many Active Accumulators are overly optimistic investors believe that bad investments will not happen to them--they will only afflict "others." Such an illusion can damage portfolios because people fail to mindfully acknowledge the potential for adverse consequences in the investment decisions they make. An example of optimism bias is when employees allocate a high proportion of their 401(k) plan as their company's stock. Undue optimism leads these employees to perceive their own firm as being unlikely to suffer from economic misfortunes.