How Advisors Can Help Preservers and Followers Succeed

This is the third article in a series focusing on behavioral investor types and intended to help advisors strengthen their relationships with their clients by helping them better understanding clients' financial personalities. Once advisors understand the various investor types at play, they can adjust their advisory approach for each type.

Last month’s article introduced four behavioral investor types. Today we'll take a deeper dive into the into Preservers and Followers, reviewing the "upside" and "downside" of working with these two specific investor types and providing suggestions about how to advise these types of clients. (We'll cover Independents and Accumulators in depth next month.)

Preservers: Upside

• Because Preservers are focused on preserving capital and avoiding losses, they tend to take a conservative approach to investing. This can be a benefit in terms of lowering volatility in a portfolio, which can lead to solid long-term compounded returns.
• Preservers who practice savings behaviors through mental accounting (saving for retirement, for college funding, for paying bills) can accumulate long term wealth as long as they are careful to invest in a balanced way across these various mental accounts.
• Preservers are also less likely to engage in excessive trading activity (which has been shown to be detrimental to wealth accumulation) because they are often subject to status quo bias; they may not change their portfolios often.

Preservers: Downside

• Preserver behavioral investor types are prone to sell at the wrong time due to excessive loss aversion during severe market downturns. Some Preservers panicked during the market meltdowns of 2000-2001 and 2008-2009 and sold out of stocks after suffering losses, only to see markets rebound in the ensuing 12 to 24 months.
• Preservers may sell their winning investments too quickly in an effort to protect gains.
• Excessive mental accounting can lead to suboptimal portfolio construction if too much cash is held across various mental accounts.
• Preservers can take too little risk when investing. For example, if Preservers focus too many of their investments on cash and bonds, they may risk not reaching their financial goals; sometimes cash and bonds simply won't get you there.
• Preservers' biases are mainly emotional, which are hard to change or moderate, especially during market upheavals. During these times, investors should consider making risky investments as opposed to selling risky investments. This is counterintuitive, especially in the heat of the moment when markets are falling, but in almost every case. it is the right decision to step in to risky asset markets when there is "blood in the streets."

Advice for Preservers After reading the upsides and downsides, readers might conclude that Preservers are difficult to advise, because they are driven mainly by the avoidance of losses, which is an emotional response to fluctuations in the value of their portfolios. Statistics have shown that long-term investments in equities, which are clearly the most volatile investment one can own, have been handsomely rewarded. Therefore, not selling at the wrong time and rebalancing at the right time can make difference between reaching and not reaching financial goals.

Preservers need good financial advice, and advisors should take the time to interpret behavioral signs provided to them by Preserver clients. Preservers need big-picture advice, and often they require behavioral coaching in addition to standard investing education. For example, advisors would probably be more effective in advising Preservers if they didn't dwell on details like standard deviations and Sharpe ratios, especially during times of market upheaval. Instead, Preservers need to understand how the portfolio they choose to create will deliver desired results related to emotional issues, such as meeting the needs of family members or future generations. Once Preservers feel comfortable discussing these important emotional issues with their advisors and a bond of trust is established, they will be more inclined to behave differently. After a period of time, Preservers are likely to become an advisor's best client, because they value greatly the advisor's professionalism, expertise, and objectivity in helping them make the right investment decisions.

Followers: Upside

• Followers are typically not overly obsessed with money and tend to lead their lives in a somewhat stress-free manner than others who tend to think about money on a daily basis. Since investing is not necessarily top of mind, Followers tend not to trade their accounts excessively, which is a big positive since trading too much has proven to be a wealth destructing activity. This low portfolio turnover can be a benefit in terms of lowering volatility in a portfolio generally, which can lead to better long-term compounded returns.
• Followers may realize that they aren't good with money and therefore make a wise decision to hire an investment advisor to help them. Advisors can bring discipline to the investing process, which is much needed with Followers.

Followers: Downside

• Followers lack of discipline during the investment process--assuming they do not hire or listen to an advisor. For example, undisciplined Followers tend to place a lot of emphasis on investing in the latest investment trends that have performed well recently. This can lead to investing in asset classes at the wrong time, which can lead to wealth destruction.
• Followers think of themselves as intelligent intelligent investors when investments go up, fooling themselves into believing they are talented when in fact a rising tide is lifting all boats. This misplaced confidence can increase risk-taking behavior, and taking on too much risk at the wrong time can lead to capital losses.

Advice for Followers Followers often overestimate their risk tolerance. Risky trend-following behavior occurs in part because Followers don't like the task of investing, or they feel overt discomfort at the thought of buying 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.

As a result, 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 interest. Advisors should guide Followers to take a hard look at behavioral tendencies that may cause them to overestimate their risk tolerance. 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 also challenge Follower clients to be introspective and provide data-backed substantiation for recommendations they receive. If advisors take the time, this steady, educational approach will generate client loyalty and adherence to long-term investment plans.

Michael M. Pompian, CFA, CAIA, CFP, is the founder and chief investment officer of Sunpointe Investments, an investment advisor to family offices based in St. Louis, Missouri. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients. Contact Michael at michael@sunpointeinvestments.com.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.