Learn how to create a behaviorally modified asset allocation for Followers, or passive investors.
This month's article is the seventh 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. If you missed any of these articles, you can go back and search for them on the Morningstar Advisor website. As noted in the previous article, 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 the general characteristics of each BIT.
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 Follower 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 personalities clients present is the heart and soul of the job. Sometimes the job is relatively easy: The client being advised appears rational in his approach--that is, he 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 do such things as 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 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 processes 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 asset allocation be changed. This kind of behavior is a lose-lose situation for both the advisor and the client. The client loses because his portfolio is likely to underperform when he strays from his asset-allocation policy targets (witness those who "sold out" in March 2009 only to see the market rebound dramatically). The advisor loses because he becomes ineffective and can even be blamed for the decision to change allocation even if it was the client's idea. What to do?
Creating Portfolios for Follower Clients
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 Follower. This analysis is being presented from the point of view of the advisor. If you are an individual investor, you can read the analysis from the point of view of the investor, and I hope it will make sense in terms of trying to help you understand how to create an allocation based on your particular circumstances.
As we know, Followers are passive investors who usually do not have their own ideas about investing. They often follow the lead of their friends and colleagues in investment decisions, and they want to be in the latest, most popular investments without regard to a long-term plan. One of the key challenges of working with Followers is that they often overestimate their risk tolerance. Advisors need to be careful not to suggest too many hot investment ideas; Followers will likely want to do all of them. Some don't like, or even fear, the task of investing, and many put off making investment decisions without professional advice. The result is that they maintain, often by default, high cash balances. Followers generally comply with professional advice when they get it, and they educate themselves financially, but can at times be difficult because they don't enjoy or have an aptitude for the investment process.
Scenario: Suppose you are beginning an engagement with a new client, Amy. You give her a standard risk-tolerance quiz and determine that she is a moderate risk-tolerant investor. After that, you give her a test for behavioral biases. Based on the answers to the bias questions, you determine that Amy is a Follower. Some of your other clients are moderate in their risk tolerance but they are not biased like Amy. The object of this exercise is to see how to create a behaviorally modified asset allocation for a Follower versus a nonbiased or mildly biased moderate investor. Generally, this can mean that a Follower should accept less risk in her portfolio than those clients without bias. Because Amy is a Follower, she may overstate her risk tolerance. This makes working with a Follower somewhat more challenging than with some other BITs.
The following analysis presents two investment programs, one for Bill (a nonbiased moderate investor) and one for Amy (a Follower). You are using Bill's portfolio allocation as a baseline for creating Amy's. Your basic task is to assess a retirement goal for Amy 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, Follower clients:
For Amy, a Follower, we are going to make an assumption that she may have difficulty sticking to a portfolio with a probability of a loss year at greater than 25%. For Bill, a moderate client, 25% may be too conservative and can be a bit higher. So let's examine the figure below and analyze how Amy's portfolio might compare to Bill's. Without getting too caught up in the details of the numbers, you can see that Amy has a more conservative allocation than Bill, which will likely permit her to reach her financial goals. This is an example of how one adjusts an allocation for the Follower BIT.
Advice for Followers
Advisors to Followers first and foremost need to recognize that Followers often overestimate their risk tolerance. Risky trend-following behavior occurs in part because Followers don't like situations of ambiguity that may accompany the decision to enter an asset class when it is out of favor. They also may convince themselves that they "knew it all along" when an investment idea goes their way, which also increases future risk-taking behavior. Advisors need to handle Followers with care because they are likely to say yes to investment ideas that make sense to them regardless of whether the advice is in their best long-term interests. Advisors need to lead Followers to take a hard look at behavioral tendencies that may cause them to overestimate their risk tolerances. Because Follower 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. Advisors should challenge Follower clients to be introspective and provide data-backed substantiation for recommendations. Offering education in clear, unambiguous ways so they have the chance to "get it" is a good idea. If advisors take the time, this steady, educational approach will generate client loyalty and adherence to long-term investment plans.
Summing It Up
Hopefully this article has helped you to better understand how to create portfolios for the Follower BIT. The next article in the "Deep Dives Into Behavioral Investor Types" will be the eighth in the series and the first on the Independent BIT. Thanks for reading.