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.