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When Clients Draw the Wrong Picture from Their Frame of Reference

Clients who suffer from representativeness bias may also be subject to anchoring, regret, and loss aversion bias.

Michael M. Pompian, 07/23/2012

This month's article is the tenth in a series called "Managing Behavior in a Volatile Market" and Part I of a discussion on a very important bias, representativeness. This series provides data and insight into the identification of key behavioral biases and also shows how to manage client behavior and emotion in this highly volatile market environment.

A substantial part of this series will be a review and analysis of answers to behavioral questions that were completed by a diverse set of 178 individual investors in 2011. The investors polled were not subscribers to Morningstar.com and/or Morningstar investor newsletter publications like the last survey, but they fit a similar profile in terms of investment objective and investor description.

By way of background, the survey questions were written to identify 20 key behavioral biases that I outline in my book, Behavioral Finance and Wealth Management. The second edition of the book, with updated biases and new case studies, just hit the cyber-market.

As noted in earlier articles, the intent of the survey was twofold. First, I wanted to identify the most prevalent biases ("Primary Biases"), so advisors would know what to look for when working with their clients. Second, I wanted to identify what secondary behaviors ("Secondary Biases") might also be lurking behind these primary biases. In other words, if client Smith has easily recognizable bias X, what other of the 19 biases might client Smith also be subject to?

The purpose in doing this is that advisors can hopefully recognize not only primary biases, but secondary biases as well. Often it is the unrecognizable biases that can cause substantial harm when attempting to keep clients on track to attaining financial goals. Advisors can hopefully gain significant insight into a range of a client's behavioral tendencies simply by being aware of a single common bias.

In order to rank as a primary bias, 50% or more of respondents need to answer at least "Agree" or "Strongly Agree" to a question designed to identify a certain bias.

There were seven biases that garnered at least 50% positive responses:

Loss Aversion Bias: The pain of losses is greater than the pleasure of gains

Anchoring Bias: Getting "anchored" to a price point when making an investment decision

Hindsight Bias: Believing that investment outcomes should have been able to be predicted

Recency Bias: Taking investment action based on the most recent data or trend rather than putting current situations into historical perspective

Representativeness Bias: Making current investment decisions using the results of past similar investments as a frame of reference

Status Quo Bias: Not taking action to change one's investment portfolio (i.e., doing nothing when prompted to do so)

Regret: Past (poor) decisions affect future investment decisions

When you are providing advice to clients, at a minimum you should be looking out for these seven biases, as they are likely to be the most commonly encountered. For example, let's say you identify that a client is loss averse. What are the other irrational biases they might be subject to? This series is intended to help answer this question for the seven biases listed above and provide tips on overcoming them.

In this article we will review the biases associated with representativeness bias. Fifty-three percent of 178 people responded that they agreed or strongly agreed to a question asking them if they were subject to representativeness bias (i.e., the idea that some investors tend to use prior experience as a frame of reference for current decisions). Of that group, at least half of those people were also subject to the following six biases:

1. Anchoring (71%)
2. Regret (62%)
3. Loss Aversion (61%)
4. Hindsight (54%)
5. Recency (52%)
6. Status Quo (52%)

For example, of the respondents who said they were subject to representativeness bias, 71% of them were also subject to a question designed to identify anchoring bias, and so on for the other five biases.

Below, I will provide commentary on the first three of these biases: anchoring, regret, and loss aversion. I will discuss why these biases are likely linked with representativeness and what you can do to counsel a client who has these biases.

Representativeness and Anchoring
Representativeness and anchoring certainly go together. Clients subject to Representativeness use prior experience as a frame of reference for current decisions. Clients influenced by anchoring get attached to a price point when making an investment decision.

Let's put these two ideas together in an example: Suppose that last month, June 2012, Nicole made an investment in a technology stock fund at $50 per share because the technology sector was undervalued. Further suppose that Nicole lived through the "tech wreck" of 2000 and lost a lot of money on technology stocks. Presently, the stock fund is trading at $45. Nicole is not happy with losing $5.00 per share. When thinking about the fact that she paid $50 per share, she begins to get "flashbacks" about losing lots of money in 2000 on technology stocks. She decides to sell the fund. In this case, Nicole is being negatively influenced by biases on two fronts: representativeness and anchoring. What can she do?

Advice: It is always important to keep the rationale for making an investment in mind when making buy and sell decisions, and to not let prior experiences cloud the issues. Nicole had good reason to invest in the technology stock fund because technology stocks were undervalued. In contrast, in 2000, technology stocks were very overvalued. She permitted the prior experience of losing money to color her current view. Regarding anchoring, having a strong sell discipline is certainly a good idea. Often the best investors can't call "the bottom" when making a value-based investment, and Nicole did not have enough patience with her investment horizon.

Representativeness and Regret
Representativeness and regret are connected; however, this may need some explanation. Representativeness, as we know, occurs when investors use prior experience as a frame of reference for current decisions. Regret-aversion bias occurs when people tend to avoid making decisions that will result in action because they are afraid that the decision will turn out poorly.

If an investor had a bad experience in the past with, say, international stocks, he or she may not want to make the same mistake again (regret) and may not invest in them today--despite attractive valuations--because of fear over making the wrong decision. Regret aversion can keep some investors out of a market that has recently generated losses. Having experienced losses, our instincts tell us that to continue investing is not prudent. Yet periods of depressed prices may present great buying opportunities.

Advice: My advice to those investors subject to both representativeness and regret is to accept the fact that investment mistakes will occur but not to let those mistakes color current decisions. The most important part of the investment process is that a structured program is followed and a valuation discipline is actively pursued.

Representativeness and Loss Aversion
Representativeness and loss aversion bias are naturally tied; let's take an example. When people are subject to loss aversion, they don't like to admit they were wrong by taking a loss. As noted, clients with representativeness bias use prior experience as a frame of reference for current decisions. Suppose Leo buys a cyclical stock based on a chart he saw on an investment website. Further suppose he made money a few years ago investing in cyclical stocks. Leo paid $120 for the current stock holding, and it goes down to $100 based on fundamentals. Loss aversion may lead Leo to hold this loser even if the investment has little or no chance of going back up anytime soon. His past experience may also lead him to believe that he will make money in cyclical stocks even though the fundamentals dictate otherwise.

Advice: I recommend that advisors focus their clients' attention not on losses or prior experience but rather on the prospect of a positive result from the current price. Would you make the investment now? If the answer is yes, then holding is the right course of action. If the answer is no, the right course of action becomes clear.

Conclusion
Hopefully you have learned something about representativeness and the biases connected with it. When you encounter a client with representativeness bias, think about the examples you have read about in this article. It might help to build a better client relationship!

In next month's article, we will review the second three biases associated with representativeness.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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