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Creating Portfolios for 'the Preserver' Client

Preservers emphasize financial security and preserving wealth rather than taking risk to grow wealth.

Michael M. Pompian, 04/17/2014

This month's article is the fourth in a series called "Deep Dives Into Behavioral Investor Types." This series is intended to help advisors create better relationships with their clients by deeply understanding the type of person they are dealing with from a financial perspective and being able to adjust their advisory approach to each type of client.

As we learned in my last article series, there are four behavioral investor types (BITs): the Preserver, the Follower, the Independent, and the Accumulator. If you missed any of these articles, you can find them in my article archive on MorningstarAdvisor.com.

As noted in my previous columns, the learning process for each BIT will be a series of three articles:

--Part I will be a diagnosis of a BIT and a discussion of its general characteristics.

--Part II will be a deep dive into the biases of that BIT.

--Part III will be how to create a portfolio for that BIT.

This article is Part III of the Preserver BIT.

Creating Behaviorally Modified Portfolios
For today's financial advisor, private banker, or generalist wealth management practitioner, creating viable and unique investment solutions in response to the array of financial situations and client personalities is the heart and soul of the job.

Sometimes that job is relatively easy: the client being advised appears rational in his or her approach--that is, he or she seems to understand the importance of asset allocation and has reasonable return expectations. For these clients, the typical method for arriving at an asset allocation is to administer a risk tolerance questionnaire and use financial planning software to create a mean-variance-optimized asset allocation program.

At other times, financial advisors encounter irrational behavior. Irrational clients may overestimate their risk tolerance, have unrealistic return expectations, or generally behave in a way that makes advising them difficult because they are not grounded in rational investment principles and/or resist learning them.

Most advisors have no trouble in the former case--the easy clients. In the latter case, however, some advisors get frustrated and impatient when confronted with an irrational client. In these situations, risk tolerance questionnaires and mean-variance software are often ineffective.

Understanding and applying behavioral finance solutions can help clients to meet their financial goals. But many advisors are vexed by their clients' decision-making process when it comes to allocating their investment portfolios. Why? In a common scenario, a client will, in response to short-term market movements (such as what we witnessed in late 2008 and early 2009 and more recently in the fall of 2011) demand that his or her asset allocation be changed, commonly to the detriment of the long-term investment plan. This kind of behavior is a lose-lose situation for both the advisor and the client. The client loses because the portfolio is likely to underperform when it strays from the asset allocation policy targets (witness those who "sold out" in March 2009 only to see the market rebound dramatically). The advisor loses because he or she becomes ineffective and can even be blamed for the decision to change allocation, even though it was the client's idea. What to do?

Creating Portfolios for Preserver Clients
We will begin with the Preserver BIT. (Note: For more complete case studies including the analysis of standard of living risk, see my other book, Behavioral Finance and Wealth Management.) Our process, as discussed, is to review the basics of each BIT (done in Part I of this series), discuss the primary biases at work (done in Part II of this series) and, now we will discuss how to modify an asset allocation based on each BIT--in this case the Preserver.

As we know, Preservers place a great deal of emphasis on financial security and preserving wealth rather than taking risk to grow wealth. Some Preservers obsess over short-term performance and are slow to make investment decisions because they aren't entirely comfortable with change (which is consistent with the way they have approached their professional lives), and are careful not to take excessive risks. Many Preservers are focused on taking care of their family members and future generations, especially funding life-enhancing experiences such as education and home buying. Because the focus is on family and security, Preserver biases tend to be emotional rather than cognitive. As age and wealth level increase, this BIT becomes more common.

Consider this scenario: Suppose you are beginning an engagement with a new client, Ricardo. You give him a risk tolerance quiz and determine that he is a conservative investor. After that, you give him a test for behavioral biases. Based on the answers to the bias questions, you determine that Ricardo is a Preserver. Some of your other clients are conservative, but they are not as biased as Ricardo.

The object of this exercise is to inform the creation of a behaviorally modified asset allocation for a Preserver versus a non-biased or mildly biased conservative investor. Generally, this can mean that a Preserver should accept less risk in his portfolio than those clients without bias. Since Ricardo is a Preserver, he is not predisposed to taking on additional risk to his portfolio anyway. This makes working with a Preserver an easier task than with some other BITs.

The following analysis presents two investment programs, one for Mark (a non-biased conservative investor) and one for Ricardo (a Preserver). You are using Mark's portfolio allocation as a baseline for creating Ricardo's. Your basic task is to assess a retirement goal for Ricardo and the risk associated with the return needed to reach that goal. When working with actual clients, you will need to adjust this analysis to suit your purposes.

As we know, Preserver clients:

> Are driven by emotion
> Generally want a conservative portfolio anyway

For Ricardo, a Preserver, we are going to assume that he may have difficulty sticking to a portfolio with a probability of a loss year at greater than 15%. For Mark, a conservative client, 15% may be too conservative, and the number can be a bit higher.

Let's examine the samples below and analyze how Ricardo's portfolio might compare with Mark's. Without getting too caught up in the details of the numbers, you can see that Ricardo has a more conservative allocation than Mark, which will likely permit him both to stick to his portfolio allocation and meet his financial goals. This is an example of how one adjusts an allocation for the Preserver BIT.

--Preserver (Ricardo)
Based on Ricardo's rick-tolerance questionnaire, the following portfolio was generated with its associated risk and return statistics:

Cash: 15%
U.S. Bonds: 30%
U.S. Stocks: 25%
Non-U.S. Stocks: 20%
Real Assets: 10%
Projected Return 6%
Standard Deviation: 10%
Probability of a Loss Year: 17%

After conversations with Ricardo, you determine that he needs a 5% return to meet his financial goals. You recommend the following allocation, which is a Rational Asset Allocation that delivers a 5% return and has a 13% chance of a loss year:

Cash: 20%
U.S. Bonds: 30%
U.S. Stocks: 20%
Non-U.S. Stocks: 20%
Real Assets: 10%
Projected Return 5%
Standard Deviation: 9%
Probability of a Loss Year: 13%

--Conservative Client (Mark)
Based on Mark's risk tolerance questionnaire, the following portfolio was generated with its associated risk and return statistics:

Cash: 10%
U.S. Bonds: 30%
U.S. Stocks: 25%
Non-U.S. Stocks: 25%
Real Assets: 10%
Projected Return 7%
Standard Deviation: 11%
Probability of a Loss Year: 20%

Based on conversations with Mark, you determine that he needs a 6% return to meet his financial goals. Thus, you recommend this allocation, which has a slightly higher return than he needs, but given his profile, you are comfortable with it.

Advice for Preservers
After reviewing this section, readers might correctly conclude that Preservers don't like volatility, which is true. They may feel more comfortable with a lower risk allocation. Also, advisors should take the time to interpret behavioral signs provided to them by Preserver clients. Preservers generally need big-picture advice, and advisors shouldn't dwell on details like standard deviations and Sharpe ratios, or else they will lose the client's attention.

Preservers need to understand how the portfolio they choose to create will deliver desired results to meet emotional objectives related to family members or future generations. Once they feel comfortable discussing these important emotional issues with their advisors, and a bond of trust is established, they will take action.

After a period of time, Preservers are likely to become an advisor's best clients because they greatly value the advisor's professionalism, expertise, and objectivity in helping them make the right investment decisions.

The next article in "Deep Dives Into Behavioral Investor Types" will be the fifth in the series and the first on the Follower BIT.

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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