Maximize client interaction by spotting clients' inclinations.
Last month's article introduced the 20 most-common behavioral biases that financial advisors are likely to encounter when working with their clients. Readers might have been overwhelmed with having to learn so many. Subsequent articles will, however, break out certain kinds of investors and give examples of the biases most frequently encountered, and later on readers will get information on how to use this knowledge in a practical setting.
Just as biases are the buildings blocks of the practical application of behavioral finance, assigning biases to certain risk-tolerance levels is the foundation of classifying investors into behavioral investor types. By understanding what type of client you are dealing with and the behaviors you will work with during the client relationship (especially during times of market turmoil), advisors will be armed with the skills they need to get inside the heads of their clients and anticipate what might go wrong rather than react blindly to a situation gone wrong. Ultimately, your job is to create behaviorally modified investment programs to which clients can comfortably adhere in order to meet their long-term financial goals. Before we get into the biases of conservative clients, let's review some tips on the client diagnostic process.
Biases and the Client Diagnosis
Most experienced financial advisors begin the financial planning process with a client interview. This consists mainly of a question-and-answer session intended to gain an understanding of the objectives, constraints, past investing practices, and--importantly--the risk tolerance of a client. The usual tool used to assess risk tolerance is a risk-tolerance questionnaire. Along the way, the advisor should be ascertaining whether a client is an active or a passive investor. Has the client wished (or does the client now wish) to put his or her capital at risk to build wealth? It is important to make a distinction between investing in a diversified portfolio and risking capital. Some examples of risking capital are building companies (big or small), investing in real estate using leverage beyond a primary residence, or working for oneself rather than for a large company. The idea of classifying investors as either active or passive is not new. In 1978, Marilyn MacGruder Barnewall classified investors by asking this basic question: Did an investor risk personal financial assets to create their own wealth over a lifetime? If not, these investors were identified as "passive." If so, they were dubbed "active." (Barnewall, M. 1987. "Psychological Characteristics of the Individual Investor." in William Droms, ed. Asset Allocation for the Individual Investor. Charlottsville, Va: The Institute of Chartered Financial Analysts.) It is important to understand the characteristics of active and passive investors because passive investors have tendencies toward certain investor biases, as do active investors. Here's a brief discussion of the characteristics of active and passive investors, followed by a test you can administer to clients that can help you determine their active or passive nature.
Passive investors are those investors who become wealthy by inheritance or by risking the capital of others such as stockholders, investors, or taxpayers. Passive investors usually have a high need for security and a low-to-moderate tolerance for risk. Examples of passive investors include second- or multi-generational inheritors, corporate executives, lawyers, accountants, politicians, and bankers. Active investors earn wealth during their own lifetimes. They have been actively involved in the wealth creation and have risked their own capital in achieving their wealth objectives. Active investors usually have a higher tolerance for risk than they have need for security. Related to their high risk tolerance is that active investors prefer to maintain control of their own investments. Their tolerance for risk is high because they believe in themselves. They get very involved in their own investments and like to do due diligence on contemplated investments. They are often difficult clients.
Active or Passive?
The ideal situation is for the advisor to be able to identify a client or potential client's active or passive nature subtly, through conversation, without administering a questionnaire. If the advisor prefers, here is a simple test that can either be administered by the advisor to the client, or that the advisor can fill out based on knowledge of the client.
1. Have you earned the majority of your wealth in your lifetime?
2. Have you risked your own capital in the creation of your wealth?
3. Which is stronger: your tolerance for risk to build wealth or the desire to preserve wealth?
a. Tolerance for risk
b. Preserve wealth
4. Would you prefer to maintain a degree of control over your investments or prefer to delegate that responsibility to someone else?
a. Maintain control
5. Do you have faith in your abilities as an investor?
6. If you had to pick one of two portfolios, which would it be?
a. 80% stocks/20% bonds
b. 40% stocks/60% bonds
7. Is your wealth goal intended to continue your current lifestyle or are you motivated to build wealth at the expense of current lifestyle?
a. Build wealth
b. Continue current lifestyle
8. In your work or personal life, are you generally a "self-starter" in that you seek to out what needs to be done and then do it, or do you prefer to take direction from someone else?
b. Get direction
9. Are you "income motivated" or are you willing to put your capital at risk to build wealth?
a. Capital at risk
b. Income motivated
10. Do you believe in the concept of "leverage" or do you prefer to limit the amount of debt you owe?
a. Believe in leverage
b. Limit debt
A preponderance of "A" answers indicates an active investor. "B" answers identify passive investors.
Once you have classified the investor, advisors should then administer a traditional risk tolerance questionnaire to begin the process of identifying whether or not a client falls into one of four risk categories. In the interest of keeping this article to a reasonable length, I have not included a risk tolerance questionnaire here. However, many of you have access to this type of test. Once you have determined whether client's are passive or active, there is a high likelihood that passive investors fall on the low to middle part of the risk scale, while active investors are willing to take on the middle to high end of the risk scale.
At this point, you should know whether you are dealing with a conservative client or an aggressive-growth client; these two types typically have emotional biases driving their investing decisions. Between these two extremes, look for cognitive biases. Remember that behavioral biases fall into two broad categories, cognitive and emotional. A cognitive bias is a basic, statistical information-processing or memory error common to all human beings. They can be thought of as "blind spots" or distortions 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. Often, because emotional biases originate from impulse or intuition rather than conscious calculations, they are difficult to correct. Passive, low-risk-tolerance clients typically have a high need for security, get highly emotional about losing money and like to keep things the way they are rather than making a lot of changes. Likewise, highly aggressive investors are also emotionally charged people. They suffer from high degrees of overconfidence and believe they can control the outcomes of their investments. Clients in between these two extremes suffer mainly from cognitive biases or faulty reasoning (we will discuss these types of investors in later articles). The next section will review biases of conservative clients, which, as just discussed, are dominated by emotion.
Biases of Conservative Investors
Loss Aversion Bias
Bias Type: Emotional
Conservative investors tend to feel the pain of losses more than the pleasure of gains as compared with other client types. As such, these clients might hold 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.
Status Quo Bias
Bias Type: Emotional
Conservative investors often like to keep their investments (and other parts of their lives, for that matter) the same or keep the "status quo." These investors tell themselves "things have always been this way" and feel safe keeping things the same.
Bias Type: Emotional
Conservative investors, especially clients who inherit wealth, tend to assign a greater value to investments that they already own (such as a piece of real estate or an inherited stock position) than they would if they don't possess that investment and have the potential to acquire it.
Regret Aversion Bias
Bias Type: Emotional
Conservative investors often avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Regret aversion can cause conservative investors to be too timid in their investment choices because of losses they have suffered in the past.
Bias Type: Cognitive
Conservative investors are often influenced by purchase points or arbitrary price levels. They tend to cling to these numbers when facing questions like "should I buy or sell this investment?" Suppose that the stock is down 25% from its high that it reached five months ago ($75/share versus $100/share). Frequently, a conservative client will resist selling until its price rebounds to the $100/share it achieved five months ago.
Mental Accounting Bias
Bias Type: Cognitive
Conservative clients often treat various sums of money differently based on where these sums are mentally categorized. For example, these investors segregate their assets into safe "buckets." If all of these assets are viewed as safe money, sub-optimal returns are usually the result.
So, the next time you are working with a conservative investor, 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 client's 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 moderately conservative investors.