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Commentary

Stick to the Facts to Overcome Affinity Bias

When your clients suggest investment ideas from friends and family, they may be suffering from affinity bias.

By Michael Pompian

This month's article is the 21st 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: affinity bias. Another emotional bias, affinity bias refers to an individual's tendency to make irrational, uneconomic consumer choices or investment decisions based on how they believe a certain product or service will reflect their values.

For example, a car buyer may purchase a Range Rover or a similar sport utility vehicle because they want to be perceived by others as someone who is "outdoorsy," regardless of the extent to which the person actually engages in outdoor activities. But in reality, there are much more affordable vehicle options that could easily transport them from point A to point B.

Within the investment realm, investors may choose to invest in a certain stock simply because they feel that the company reflects their values, their self-image, or how they want to be perceived by others. However, this type of investing behavior can lead to suboptimal investment results if the company producing the product or service is poorly managed or has financial or business-related problems. Due diligence in considering any investment is a necessity!

Investment Implications for Retirement Planning
A classic example of affinity bias in the retirement realm is observed when clients choose to invest in deals or securities with friends who share a common bond, such as golfing buddies or those who attend the same country club. In this case, it is critical to do fundamental research before making an investment decision, rather than invest simply because one is enamored with a company's products or services or feels a connection or association with other investors. It is your role as an advisor to ensure that your clients understand this.

I am frequently asked by my clients to evaluate investment prospects suggested by their friends. Sometimes, based on research, these investments are sound. Other times, they are not. Even in situations where they prove to be a sound investment, they still may not be suitable for a client's investment strategy. It is critical to stick to the facts about the viability of the investment and its fit within the overall asset allocation strategy.

It can be hard for clients to stick to a diversified asset allocation plan. Our role as financial advisors is to keep clients on track toward their long-term financial goals. Sometimes the role of the advisor is to not only help clients make good decisions but also to help them avoid making bad ones. Encouraging them to be diversified in a disciplined plan is the best strategy for dealing with affinity bias. By staying diversified and investing across regions and asset classes, you should be able to gain trust and confidence of your clients and help them achieve their long-term goals.