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Behavioral Investor Types: The Friendly Follower

Friendly Followers benefit most from information about their biases so they can make better investment decisions.

Michael M. Pompian, 04/16/2009

In last month's column we reviewed the first of four behavioral investor types, the Passive Preserver. If you recall, behavioral investor types are the foundation of the Behavioral Alpha system which 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.

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. Passive Preservers, which are the least risk tolerance, fall into this category. You should remember that the two BITs in the middle of the risk scale are affected mainly by cognitive biases. Friendly Followers, the focus of this article, are less emotionally biased than they are cognitively biased when making investment decisions. This should make intuitive sense. Clients who have a high need for security (in other words, 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 Friendly Followers are cognitively biased, they should be advised differently than those who make get highly emotional about their investing. An educationally oriented quantitative approach is usually 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.

The ultimate goal, as I have pointed out many times, is to build better long-term relationships with client; BITs are designed to help in this effort. In this article, we begin with a passive investor who is modestly conservative and cognitively biased: the Friendly Follower.

Friendly Follower Behavioral Investor Type
Basic type: Passive
Risk tolerance level: Low to Medium
Primary bias: Cognitive
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--FFs 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.

Recency Bias
Bias Type: Cognitive
Recency bias is a predisposition for investors to recall and emphasize recent events and/or observations. They may extrapolate patterns where none exist. Recency bias ran rampant during the bull market period between 2003 and 2007 when many investors wrongly presumed that the stock market, particularly energy, housing, and international stocks, would continue gains continuously. Moderate investors are known to enter or hold on to investments when prices are peaking, which can end badly, with sharp price declines.

Hindsight Bias
Bias Type:
Moderate clients often lack independent thoughts about their investments and are susceptible to hindsight bias which occurs when an investor perceives investment outcomes as if they were predictable. An example of hindsight bias is the response by investors to the financial crisis of 2008. Initially, many viewed the housing market's performance from 2003 to 2007 as "normal" (in other words, not symptomatic of a bubble), only later to say, "Wasn't it obvious?" when the market melted down in 2008. The result of hindsight bias is that it gives investors a false sense of security when making investment decisions, emboldening them to take excessive risk without recognizing it.

Framing Bias
Bias Type: Cognitive
Framing bias is the tendency of investors to respond to situations differently based on the context in which a choice is presented (framed). Often, moderate investors focus too restrictively on one or two aspects of a situation, excluding other considerations. The use of risk tolerance questionnaires provides a good example.  Depending upon how questions are asked, framing bias can cause investors to respond to risk tolerance questions in an either unduly risk-averse or risk-taking manner. For example, when questions are worded in the gain frame (an investment goes up) then a risk-taking response is more likely. When questions are worded in the "loss" frame (an investment goes down), then risk-averse behavior is the likely response.

Cognitive Dissonance Bias
Bias Type: Cognitive
In psychology, cognitions represent attitudes, emotions, beliefs or values. When multiple cognitions intersect--for example a person believing in something only to find out it is not true--people try to alleviate their discomfort by ignoring the truth and/or rationalizing their decisions. Investors who suffer from this bias may continue to invest in a security or fund they already own after it has gone down (average down) even when they know they should be judging the new investment with objectivity. A common phrase for this concept is "throwing good money after bad."PAGEBREAK

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