Moderate types often overestimate their risk tolerance.
In September's column, we examined the biases of conservative investors and introduced the Behavioral Alpha process of classifying investors into their behavioral investor types. In this month's column, we will move on to biases of moderate investors, finishing our coverage of clients who are at the lower end of the risk tolerance scale.
In the current market environment, many conservative investors have been able to weather the market downturn effectively because they have structured their portfolios with downside protections. Some moderate investors have done likewise, having fared better than aggressive investors but not as well as conservative ones. Other moderate investors overestimated their risk tolerance: At best, they are disappointed with their results; at worst, they are fearful about the condition of their portfolios.
Our job as financial advisors is to help clients better understand how they might react to situations like the one we find ourselves in today and create investment programs accordingly. Understanding the behavioral biases of your clients will help you do just that, especially when we get to behavioral investor types later in the series. Before we delve into the biases of moderate investors, let's review what we have covered in past articles.
The purpose of studying and identifying behavioral biases is that eventually we will be classifying investors into behavioral investor types. This process starts with ascertaining whether a client is an active or a passive investor. Passive investors become wealthy by risking the capital of others such as stockholders, investors, or taxpayers or by inheritance. Passive investors usually have a high need for security and a low-to-moderate tolerance for risk. Active investors have been actively involved in wealth creation, risking their own capital to achieve their wealth objectives. Active investors have a higher tolerance for risk than they have need for security.
Once the investor is classified as active or passive, he or she then completes a traditional risk tolerance questionnaire placing them into one of four risk categories. There is a high likelihood that passive investors fall on the low- to middle-part of the risk scale, and that active investors are on the middle- to high-end of the risk scale. At this point, you know whether you are dealing with a conservative client, a moderate client, a growth-oriented client, or an aggressive-growth client.
The next task is to identify the behavioral biases of the client to determine the behavioral investor type. Today, we will look at biases of moderate risk-tolerance investors. Remember that behavioral biases fall into two categories: cognitive and emotional. A cognitive bias is a statistical information-processing or logic error--a "blind spot" or distortion in the human mind. Emotional biases are on the other end of the spectrum from illogical or distorted reasoning. Emotions are expressions, often involuntary, related to feelings, perceptions, or beliefs about elements, objects, or relations between them, in reality or in the imagination.
Moderate and growth-oriented clients primarily have cognitive biases driving their investing decisions; conservative and aggressive-growth clients typically have emotional biases. Because behavioral biases are the building blocks of classifying behavioral investor types, it is important for advisors to be able to recognize them. We will review biases of moderate clients, which are dominated by cognitive biases or errors in logical reasoning. Many of these biases can lead moderate investors to overestimate their risk tolerance.
Biases of Moderate Investors
Bias Type: Cognitive
Recency bias is a predisposition for investors to recall and emphasize recent events and 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 gain continuously. Moderate investors are known to enter or hold on to investments when prices are peaking, which can end badly, with sharp price declines.
Bias Type: Cognitive
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," 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.