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Behavioral Biases of Growth-Oriented Investors

If your client's at the higher end of the risk-tolerance scale, these biases might come into play.

Michael M. Pompian, 12/04/2008

In October's column, we examined the biases of moderate investors. If you recall, many of the biases of moderate investors were cognitive. In this month's column, the fifth so far, we will move to biases of growth-oriented investors, beginning coverage of clients who are at the higher end of the risk tolerance scale. Growth-oriented investor biases are also mainly cognitive. In the current market environment, many growth-oriented investors with equity allocation of 50% or more have suffered (potentially serious) losses with equity markets down almost 20% in October 2008 alone. The volatility of the equity markets is in uncharted territory. And these investors often have only modest levels of cash and bonds in their portfolios to help them weather market downturns effectively. This unhappy circumstance has brought up some very uncomfortable conversations between advisor and client. It is at times like this that overall risk tolerance can be reassessed because growth-oriented clients are often comfortable with risk in rising markets, but not in down markets. Hopefully, advisors have done a good enough job of identifying the true risk tolerance of their clients and, even better, identified any psychological biases that a client might have ahead of time that will help them deal with the current state of the market, and, by extension, their portfolio losses. If not, this column should help. We will cover the behavioral biases of growth-oriented clients, which will help you to work through some potentially difficult conversations.

Growth-oriented 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 typically have a higher tolerance for risk than they have need for security. As such, this type of client will normally fall in the middle to high end of the risk tolerance scale. Growth-oriented clients primarily have cognitive biases driving their investing decisions; the good news is that many of these biases can be treated with education and information since cognitive biases emanate from faulty reasoning or logic errors as opposed to emotional biases that emanate from feelings which are difficult to correct. 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 Growth-Oriented Investors

Conservatism Bias
Bias Type: Cognitive
Conservatism bias occurs when people cling to a prior view or forecast at the expense of acknowledging new information. Growth-oriented investors 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. The growth-oriented investor might cling to the initial, optimistic impression of the new product announcement and fail to take action on the negative announcement.

Availability Bias
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 growth-oriented investor 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.

Representativeness Bias
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. A client 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 investors might 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 to innate talents while blaming failures on outside influences. For example, suppose an investor makes an investment in a particular stock that goes up in value. In this type of investor's mind, the reason the stock 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.

Confirmation Bias
Bias Type: Cognitive
Confirmation bias occurs when people observe, overvalue, or actively seek out information that confirms their claims, while ignoring or devaluing evidence that might discount their claims. Confirmation bias can cause investors to only seek out information that confirms their beliefs about an investment, and not seek out information that may contradict their beliefs. This behavior can leave investors in the dark regarding, for example, the imminent decline of a stock. Growth-oriented investors often find themselves subject to this bias.

So, the next time you are working with your growth-oriented 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 review the biases of aggressive growth investors. After we finish reviewing the biases of aggressive growth clients, we will move to using behavioral investor types to build better relationships with your clients.

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