How to Advise Preservers

This is the sixth article in a series focusing on behavioral investor types and is 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, we reviewed the case of Gina Fleming, a high net worth individual. Here are some of the salient points about the case:

• Mrs. Gina Fleming is a single, 70-year-old retiree living an exclusive lifestyle. 
• Her annual living expenses are approximately $400,000, including taxes. 
• Her only income is generated by her $5 million of investments and is about 2% of the portfolio.
• Her spending rate is 8%, so she is spending down her principal. 
• Her goals are to sufficiently support her for the rest of her life (perhaps 20 years), with a low tolerance for risk. She also has a goal of donating $2 million to a charity for animals, if possible.
• She feels the pain of losses more than the pleasure of gains.
• She is stubborn and inflexible in her thinking, especially when it comes to financial markets.
• She likes to keep things as they are, even if the world around her is changing.
• When markets are falling, she says that she would be "crazy to invest now, markets are going down," and when they are up she says, "have we missed it?"
• She hasn't changed her portfolio structure once since you began working with her three years ago.  
• 50% of her portfolio is in Treasury bonds and high-grade municipal bonds.  
• 10% of her portfolio is in a large concentrated position in Exxon Mobil (XOM) stock, which she wants to hold because the stock belonged to her husband who passed away several years ago. 
• The rest of the portfolio is in cash (40%). 

As her advisor, you are concerned that given her conservative allocation, she will be unable to sustain her lifestyle or reach her financial goals. You suspect her discomfort at the prospect of re-allocating her portfolio is due to one or more behavioral biases. You are also trying to ensure that she feels comfortable enough with your investment solution that she will not decide to change it in six months. To better understand her situation, we are going to answer the following questions and then will provide a suggested solution to her investment situation.

1. What is her behavioral investor type?
2. What behavioral biases might drive her behavior and decision-making? What specific evidence leads you to this diagnosis?
3. How might her personal biases affect the asset allocation decision?
4. How should the advisor approach the client to moderate or adapt the impact of these biases?
5. What is a reasonable allocation recommendation? 
6. How should you as the advisor facilitate the client conversation so that the client makes a good and thoughtful investment decision and shows more consistent investor behavior?

Case Study:  Answers to Questions
Fleming's biases are very consistent with a preserver behavioral investor type. We know that because, based on the descriptions in the case study, she has the following biases:

• Loss aversion bias: the tendency to feel the pain of losses more acutely than the pleasure of gains.
• Anchoring bias: clinging to arbitrary pricing levels when considering an investment.
• Status quo bias: the desire to keep things as they are.
• Endowment: irrationally holding on to an investment regardless of possibly poor expected outcome.

The preserver prefers a conservative portfolio. Because she does not tolerate risk (loss aversion) and does not like change (status quo), she would naturally prefer the current asset allocation (90% bonds and cash and 10% stock) that she now possesses. Also, given the stock market's recent volatility, Fleming will likely make faulty conclusions regarding current and expected prices (anchoring) and will therefore feel wary of any exposure to equities. Fleming has dismissed any advisor's attempts in the past (including you) to get her to increase her exposure to equities. 

She might outlive her assets if she adheres to her present allocation. Her level of wealth, while adequate at present, isn't substantial enough to afford her the (dubious) luxury of an unbalanced allocation of funds in the long run. If you adapt to her biases--meaning you consent to stick with 90% bonds and cash and 10% equities--then her only critical, financial goal becomes jeopardized. However, her biases are largely emotional (status quo, loss aversion) and typically cannot be corrected with advice and information. This will complicate things if you attempt to moderate her biases.

It is therefore your task to make a blended recommendation, one that takes into account her financial goals while at the same time considers her emotional (difficult to correct) biases. You decide that a reasonable allocation is 35% equity, 20% cash, 45% bonds. You also think that she should to reduce her concentrated position in Exxon stock in a tax-efficient way. You call her to schedule a meeting to go over your recommendations. When you have your meeting, you decide that you will accomplish the following as it relates to explaining your recommendations and her reactions to them:

• Listen. Seek to understand. Listen actively.
• Clarify. Confirm your understanding of her desires and ask clarifying questions to go deeper.
• Empathize. Summarize your understanding and demonstrate that you see her perspective. If appropriate, acknowledge her feelings about the topic.
• Explore. Rationally explore the alternatives to consider. 
• Answer. When you make your recommendation, explain why it is the rational choice. Connect the recommendation to the vision of the goal by inviting the client to "imagine" what success will feel like.
• Check. Check for agreement.

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.