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Conservatism Bias: Why Some Clients Won't Change Their Minds

Clients often cling to their prior views or forecasts at the expense of acknowledging new information.

Michael M. Pompian, 06/23/2016

This month's article is the 17th in a series called "Behavioral Finance and Retirement," which is intended to provide insight to advisors on the unique needs and financial behaviors of clients who are entering that period of transition called "retirement."

I put retirement in quotation marks because people today are not retiring the way they used to. The days of the retirement party, the gold watch, and sitting out one's years doing crossword puzzles and watching "Wheel of Fortune" are over for most people.

We've all heard the analogy that the baby boomers are like a baseball going through a garden hose. Well, the baseball is getting to the end of the hose, and it's not leaving without a bang! And before it leaves, it will be a financial force to be reckoned with.

To serve retired clients properly, there are some key themes that advisors need to be aware of:

1. People are living longer than ever thanks in part to medical technology and better living habits such as diet and exercise. This is extending the length of time people are in a nonworking phase of life.

2. People's definition of retirement is changing, which is having a major impact on how individuals manage their finances.

3. In some cases, a certain segment of the population will have no choice but to produce some type of income after they leave the traditional workforce.

4. The responsibility of planning and investing for retirement has shifted in large part to the employee/retiree and away from corporations. As a result, behavioral biases significantly affect individuals who are entering or already in this phase of life.

In this article we are exploring another bias that affects investments in the retirement planning process: conservatism bias. A belief perseverance bias, conservatism bias occurs when people cling to their prior views or forecasts at the expense of acknowledging new information. This bias causes investors to underreact to new information or maintain impressions derived from a previous estimate they made rather than acting on new or updated information.

For a simple example in the investment realm, suppose that a research analyst who follows the pharmaceutical industry receives some bad news regarding corporate earnings for one of the companies she covers, and that this news negatively contradicts another estimate issued the previous month. Analysts subject to conservatism are slow to change their minds and persevere in their previously held belief rather than quickly adapting based on new information.

In short, smart people make forecasts. They, of course, don't want to be wrong, so they stick with their call. In some cases, this viewpoint is rewarded. In other cases, it simply doesn't make sense to continue holding a poorly performing investment when there could be other/better uses for the capital spent on that decision.

Investment Implications for Retirement Planning
Let's consider a specific investment example of conservatism bias that I encountered as an advisor. Suppose its 2010 and you have a U.S. client who is a young retiree, 62 years old, and that client spent a considerable amount of time doing business in Europe and Japan during her career. During 2011, non-U.S. developed markets were very cheap from a P/E perspective. Because of this, she insists on having a large percentage of her equity portfolio in overseas investments.

"I know the European and Japanese markets, and I believe in them and think they will do well--so I want to overweight my portfolio by 40% versus the U.S.," she says.

You try to convince her that she should be a bit more cautious because there are several big economic issues happening there that could cause stock markets to underperform versus other developed countries like the United States. You present data that both regions have demographic problems and inflation has not been present--in short you argue that their economies have serious issues.

Unfortunately, she refuses to acknowledge the evidence and decides to overweight these areas. This is classic conservatism bias in action. She has made a forecast that these markets would do well, but we now know what actually happened: The U.S. stock market did very well, and Europe and Japan are still recovering what was lost in the crisis of 2008-2009.

When dealing with conservatism bias, my advice is to encourage your clients to be more flexible in their thinking. Although it may appear "weak" to not act on the courage of one's convictions (because in investment management, sticking to one's views can be well-rewarded), my belief is that one should not take such extreme positions--as much can go wrong. If you want to take an overweight position, do so with perhaps 10%-20% of the position. If you are right, you will be rewarded; if you are not, then risk of lost opportunity is minimized.

As for me, I am hyper-aware if I am engaging in conservatism bias, and I am no longer afraid to change my mind or temper my beliefs. I encourage you to do the same.


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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