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Building a Portfolio for the Independent Client

Truly independent clients may need to take less risk in their portfolios than those clients without bias.

Michael M. Pompian, 10/23/2014

This month's article is the 10th 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 the last series, there are four behavioral investor types, or BITs: the Preserver, the Follower, the Independent, and the Accumulator. As noted in previous articles, the learning process for each BIT will be a series of three articles:

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

2. Part II will be a deep dive into the biases of each BIT.

3. Part III will be how to create a portfolio for each BIT.

This article is Part III of the Independent BIT.

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

Sometimes the 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 behaviors in their clients. Irrational clients may overestimate their risk tolerance, be unrealistic in their return expectations, or generally behave in a way that makes advising them difficult because they are not grounded in rational investment principles and/or they 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 often vexed by their clients' decision-making process when it comes to allocating their investment portfolios. Why? In a common scenario, a client, 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--and to the detriment of the long-term investment plan, demands that his or her asset allocation be changed. This kind of behavior is a lose-lose situation for both the advisor and the client. Clients lose because their portfolio is likely to underperform when they stray from their 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 if it was the client's idea. What to do?

Traits of the Independent Client
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 discuss how to modify an asset allocation based on each BIT--in this case the Independent.

As we know, Independents have original ideas about investing and like to get involved in the investment process. Unlike Followers, they are not disinterested in investing but are engaged in the financial markets, and they may have unconventional views on investing. This "contrarian" mind-set, however, may cause Independents not to believe in following a long-term investment plan.

With that said, many Independents can and do stick to an investment plan to accomplish their financial goals. At their essence, Independents are analytical, critical thinkers who make many of their decisions based on logic and their own gut instinct. They are willing to take risks and act decisively when called upon to do so.

Independents can accomplish tasks when they put their minds to it; they tend to be thinkers and doers as opposed to followers and dreamers. Unfortunately, some Independents are prone to biases that can torpedo their ability to reach goals. For example, Independents may act too quickly, without learning as much as they can about their investments before making them. They may mistake reading an article in a business news publication for doing original research. In their half-ready, full-on pursuit of profits, they may leave some important stones unturned that could trip them up in the end.

Independents' risk tolerance is relatively high, and so is their ability to understand risk. Independents are realistic in understanding that risky assets can, and do, go down. However, when their investments go down, they don't like to admit that they were wrong or that they made a mistake (sound familiar?).

Independents often do their own research and don't feel comfortable with an investment until they have confirmed their decision with research or some form of corroboration. They are comfortable collaborating with advisors, though typically they use their advisors as sounding boards for their own ideas. Independents are often comfortable speaking the language of finance and understand financial terms including market- and economy-related terms. They aren't afraid to delve into the details of investments, including the costs and fees of making investments.

Building a Portfolio for the Independent Client
Suppose you are beginning an engagement with a new client, Leo. You give him a standard risk-tolerance quiz and determine that he is a growth-oriented investor. After that, you give him a test for behavioral biases. Based on the answers to the bias questions, you determine that Leo is an Independent. Some of your other clients are growth-oriented in their risk tolerance, but they are not biased like Leo.

The object of this exercise is to see how to create a portfolio for an Independent versus a nonbiased, or mildly biased, growth investor. Generally, this can mean that an Independent should accept less risk in his portfolio than those clients without bias. Since Leo is an Independent, he may want to make investments in his portfolio outside of a recommended plan, which may change the risk level in his overall portfolio without his realizing it. This makes working with an Independent somewhat more challenging than with some other BITs.

The following analysis presents two investment programs, one for Jack (a non-biased growth investor) and one for Leo (an Independent). You are using Jack's portfolio allocation as a baseline for creating Leo's. Your basic task is to assess a retirement goal for Leo 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, Independent clients:

> Are driven by cognitive biases
> May make investments outside of a recommended plan

For Leo we are going to make an assumption that he may have difficulty sticking to a portfolio with a probability of a loss year at greater than 35%. For Jack, a non-biased growth client, 35% may be tolerable. Let's examine Figure 1 and analyze how Leo's portfolio might compare to Jack's.

Without getting too caught up in the details of the numbers, you can see that Leo has a more conservative allocation than Jack, which will likely permit him to reach his financial goals. This is an example of how one could adjust an allocation for the Independent BIT.

Advice for Independents
Independents can be difficult clients to advise due to their independent mind-set, but they are usually grounded enough to listen to sound advice when it is presented in a way that respects their independent views. Independents are firm in their belief in themselves and their decisions, but they can be blinded to contrary thinking.

Because Independent biases are mainly cognitive, education on the benefits of portfolio diversification and sticking to a long-term plan is usually the best course of action. A good approach is to have regular educational discussions during client meetings. This way, the advisor doesn't point out unique or recent failures, but rather educates regularly and can incorporate concepts that he or she feels are appropriate for the client.

Advisors should challenge their Independent client to reflect on how they make investment decisions and provide data-backed substantiation for recommendations. Offering education in clear, unambiguous ways is an effective approach. If advisors take the time, this steady, educational approach should yield positive results.

Hopefully this article has helped you to better understand how to create portfolios for the Independent BIT. The next article in the "Deep Dives into Behavioral Investor Types" will be the 11th in the series and the first on the Accumulator 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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