Passive Preservers place a great deal of emphasis on financial security and preserving wealth.
For those of you who have been reading my articles regularly, you have undoubtedly noticed that I have been laying the foundation for what we are going to learn in the next four columns: how to advise clients based on their investor behavior. In last month's column we reviewed Behavioral Alpha, a system I developed to more easily apply behavioral finance in practice which is based on more than a decade of research that classifies investors into behavioral investor types. BITs build on key concepts I outlined some of my early papers as well as my book Behavioral Finance and Wealth Management.
One of the most important concepts advisors should keep in mind as they go through the next four articles is that the least risk tolerant BITs and the most risk tolerant BITs 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 (that is, 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 they can control the outcomes of their investments. In between these two 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.
Most importantly, clients who are emotional about their investing need to be advised differently than those who make mainly cognitive errors. When advising emotionally charged investors, advisers need to focus on how the investment program being created impacts important emotional issues like financial security, retirement or the goals for future generations rather than focusing on portfolio details like standard deviation and Sharpe ratios. A quantitative approach is more effective with clients who are less emotional and tend to make cognitive errors. Emotional clients tend to be more difficult clients to work with and advisors who can recognize the type of client they are dealing with prior to making investment recommendations will be much better prepared to deal with irrational behavior when it arises. At the end of the day, the goal is to build better long-term relationships with client; BITs are designed to help in this effort. In this article, we begin with the most conservative and emotional of investors, the Passive Preservers.
Basic Type: Passive
Risk-Tolerance Level: Low
Primary Biases: Emotional
Passive Preservers are, as the name implies, passive investors who place a great deal of emphasis on financial security and preserving wealth rather than taking risk to grow wealth. Many have gained wealth through inheritance or conservatively by working in a large company. Because they have gained wealth by not risking their own capital, PPs may not be highly financially sophisticated. Some Passive Preservers are "worriers" in that they obsess over short-term performance and are slow to make investment decisions because they aren't entirely comfortable with change--which is consistent with the way they have approached their professional lives--being careful not to take excessive risks.
Many Passive Preservers are focused on taking care of their family members and future generations, especially funding life-enhancing experiences such as education and home buying. Because the focus is on family and security, PP biases tend to be emotional rather than cognitive. As age and wealth level increase, this BIT becomes more common. Although not always the case, many PPs enjoy the wealth management process--they like the idea of being catered to because of their financial status--and thus are good clients generally. Behavioral biases of PPs tend to be security-oriented biases such as endowment bias, loss aversion, status quo, and regret. Passive Preservers also often exhibit cognitive biases such as anchoring and mental accounting. What follows is a description of the biases just discussed (this should be a review for most of you) and a quick diagnostic for each bias.
Bias Type: Emotional
PPs tend to feel the pain of losses more than the pleasure of gains as compared with other client types. As such, these clients may hold only losing investments too long--even when they see no prospect of a turnaround. Loss-aversion is a very common bias and is seen by large numbers of financial advisors.
A simple diagnostic for loss-aversion bias: Provide your client a scenario in which they buy a security and it drops 25% with no foreseeable rebound. Ask if they are likely to hold it until it gets back to even or sell it and buy something with better prospects. If they hold onto the investment, they are likely to have loss-aversion bias.
Status Quo Bias
Bias Type: Emotional
PPs often prefer to keep their investments (and other parts of their life for that matter) the same or keep the "status quo." These investors tell themselves "things have always been this way" and thus feel safe keeping things the same.
A simple diagnostic for status quo bias: Ask the client if they are more comfortable keeping things the same or whether they can embrace change with investments or life in general. If they like to keep things the same, they are likely to be affected by status quo bias.