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Behavioral Biases of Aggressive Investors

Aggressive investors can be very difficuly to advise.

Michael M. Pompian, 12/18/2008

In last month's column, we examined the biases of growth-oriented investors. If you recall, many of the biases of growth-oriented investors were cognitive. In this month's column, the sixth so far, we will move to biases of aggressive investors, finishing coverage of clients who are at the higher end of the risk tolerance scale. Aggressive investor biases are mainly emotional which is very important to recognize when working with these investor-types. In the current market environment, many aggressive investors, with equity allocations of up to 60% or even more, have suffered serious losses with equity markets down almost 40% year-to-date through mid-December 2008. The velocity with which these losses have occurred has shocked and dismayed aggressive investors. What many advisors are learning is that aggressive investors like to take risk when the markets rise, but clearly don't like it when markets swoon. The silver lining of the current environment is that an investor true risk tolerance can be identified. The dark cloud over this environment, however, is that aggressive have only modest levels of cash and bonds in their portfolios to help them weather this downturn effectively and this situation leaves little in the way of new money being able to take advantage of below average long-term equity valuations.

This present circumstance has brought on some extremely difficult and challenging (potentially volatile) conversations between advisor and client. This situation tests the mettle of advisors and their ability to help their clients through extremely arduous times. In fact, I will go so far as to say that the current environment coupled with an aggressive investor who has lost 50% of his or her portfolio is perhaps the most difficult circumstance that exists in this business (in a diversified portfolio context.) To make it through, it is critical for advisors to realize the negative effect that occur as a result of aggressive investors being driven mainly by emotion in their investment decisions. Advisors need to use different tactics than they would with other, clients who are affected by cognitive biases, to get them to put into perspective what is happening when markets crater. Once we complete a review of the behavioral biases of growth-oriented clients, I will offer some advice for dealing with aggressive clients who have lost money.

As a reminder, aggressive clients are typically active investors, meaning that they have been actively involved in wealth creation, risking their own capital to achieve their wealth objectives. This makes them naturally prone to taking risk in their investment portfolios. Active investors have a higher tolerance for risk than they have need for security. As such, aggressive clients naturally fall in the high end of the risk tolerance scale and primarily have emotional biases driving their investing decisions. By way of review, emotions are physical expressions, often involuntary, related to feelings, perceptions or beliefs about elements, objects or relations between them, in reality or in the imagination. Often, because emotional biases originate from impulse or intuition rather than conscious calculations, they are difficult to correct. This is especially true with aggressive investors. Also, since behavioral biases are the building blocks of classifying behavioral investor types, which we will discuss in subsequent columns, it is important for advisors to be able to recognize them.

Biases of Aggressive Investors
Overconfidence Bias

Bias Type: Emotional and Cognitive
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 aggressive investors 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 because of unwarranted belief in their ability to assess the correct value of investment securities.

Self-Control Bias
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 aggressive client who prefers aggressive investments and has high current spending needs and suddenly the financial markets hit some severe turbulence. This client may be forced to sell solid long-term investments that have had been priced down due to current market conditions just to meet current expenses.

Optimism Bias
Bias Type: Emotional
Many 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 401K plan as their company's stock.. Undue optimism leads these employees to perceive their own firm as being unlikely to suffer from economic misfortunes. PAGEBREAK

Illusion of Control Bias
Bias Type: Cognitive
The illusion of control bias occurs when people believe that they can control or, at least, influence investment outcomes when, in fact, they cannot. Aggressive investors who are subject to illusion of control bias believe that the best way to manage an investment portfolio is to constantly adjust it. For example, trading-oriented investors, who accept high levels of risk, believe themselves to possess more "control" over the outcome of their investments than they actually do because they are "pulling the trigger" on each decision.

Aggressive clients are the most difficult clients to advise, particularly those who have experienced losses. Because they like to control or at least get deeply involved in the details of investment decision-making, they tend to eschew advice that might keep their risk tolerance in check. And they are emotionally-charged and optimistic that their investments will do well, even if that optimism is irrational. Some AAs need to be monitored for excess spending which, when out of control, can inhibit performance of a long-term portfolio. The best approach to dealing with these clients in my view is to take control of the situation. If the advisor lets the aggressive client dictate the terms of the advisory engagement, they will always be at the mercy of the client's irrational decision-making and the result will likely be an unhappy client and an unhappy advisor. Advisors need to prove to the client that they have the ability to make great, objective long-term decisions and can communicate these results in an effective way. Advisors who can demonstrate the ability to take control of a situation will see their aggressive, emotionally-charged clients fall into step and be better clients that are easier to advise.

So, the next time you are working with your aggressive investors, look for these biases. Be aware that you may not see all of them. But even recognizing one or two biases should help you understand your clients' behavior better and lead to better communication and a clearer understanding of the motivations behind their investment tendencies. Next month we will begin our work with behavioral investor types. The purpose of classifying your clients into behavioral investor types is to build better relationships with them. Identifying behavioral investor types will leverage the learning from the first six articles so if you need to, you can go back and review each of the articles that I have written over the past six months to make sure you are prepared for next month's article.

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