Independent Individualists are strong-willed and independently minded active investors.
Last month's column reviewed the second of the four behavioral investor types, the Friendly Follower. This month, we will review the third, the Independent Individualist. If you recall, behavioral investor types are the foundation of the Behavioral Alpha system I developed to more easily apply behavioral finance in practice which is 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 (Wiley 2006).
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. Both Friendly Followers and Independent Individualists are the two BITs in the middle of the risk scale and are affected mainly by cognitive biases when making investment decisions. 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. Because Independent Individualists are cognitively biased, they should be advised differently than those who make get highly emotional about their investing. An educationally oriented, quantitative advisory approach is effective with clients who are less emotional and tend to make cognitive errors; these investors benefit most from information about their biases so they can make better investment decisions.
With Independent Individualists, we are entering the realm of the active investor. These investors have been actively involved in their wealth creation, typically risking their own 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 maintain at least some amount of control of their own investments. They want 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 to the first of two active behavioral investor types, the Independent Individualist.
Basic type: Active
Risk tolerance: Medium to high
Primary Bias: Cognitive
An Independent Individualist is an active investor with medium-to-high risk tolerance who is strong-willed and an independently minded thinker. Independent Individualists 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 advisors find that an Independent Individualist client made an investment without consulting anyone. This approach can be problematic because, as a result of their independent mindset, these clients often irrationally cling to the views they had when they made an investment, even when market conditions change making 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.
Bias Type: Cognitive
Conservatism bias occurs when people cling to a prior view or forecast at the expense of acknowledging new information. Independent Individualists often cling to a view or forecast, behaving too inflexibly when presented with new information. For example, assume an investor purchases a security based on the knowledge about a forthcoming new product announcement. The company then announces that it is experiencing problems bringing the product to market. Independent Individualists may cling to the initial, optimistic impression of the new product announcement and may fail to take action on the negative announcement.
Bias Type: Cognitive
Availability bias occurs when people estimate the probability of an outcome based on how prevalent that outcome appears in their lives. People exhibiting this bias perceive easily-recalled possibilities as being more likely than those prospects that are harder to imagine or difficult to comprehend. As an example, suppose a, Independent Individualist is asked to identify the "best" mutual funds. Many of these investors would perform a Google search and, most likely, find funds from firms that engage in heavy advertising--such as Fidelity or Schwab. Investors subject to availability bias are influenced to pick funds from such companies, despite the fact that some of the best-performing funds advertise very little if at all.
Bias Type: Cognitive
Representativeness bias occurs as a result of a flawed a perceptual framework when processing new information. To make new information easier to process, some investors project outcomes that resonate with their own pre-existing ideas. An Independent Individualist might view a particular stock, for example, as a value stock because it resembles an earlier value stock that was a successful investment--but the new investment is actually not a value stock. For instance, a high-flying biotech stock with scant earnings or assets drops 25% after a negative product announcement. Some Independent Individualists may take this situation to be representative of a "value" stock because it is cheap; but biotech stocks don't typically have earnings while traditional value stocks have had earnings in the past but are temporarily underperforming.
Self-Attribution (Self-Enhancing) Bias
Bias Type: Cognitive
Self-attribution bias refers to the tendency of people to ascribe their successes' innate talents while blaming failures on outside influences. For example, suppose an Independent Individualist makes an investment in a particular stock that goes up in value. The reason it went up is not due to random factors such as economic conditions or competitor failures (the most likely reason for the investment success), but rather to the investor's investment savvy (likely not the reason for the investment success.) This is classic self-enhancing bias.