This is the ninth article in a series focusing on behavioral investor types and intended to help advisors strengthen their relationships with their clients by helping them better understand clients' financial personalities. Once advisors understand the various investor types at play, they can adjust their advisory approach for each type.
We have reached the point in this series where you will practice applying your learning of behavioral finance using a fictional client case study. The key questions to be answered are:
- What personal biases might drive the client's behavior and decision-making?
- What is the client's behavioral investor type?
- How might the client's personal biases affect the investment strategy and solution decision?
- How should the advisor approach the client to moderate or adapt the impact of these biases?
- What is the best investment strategy and solution for the client?
For the case study, assume today's market environment. That is, the U.S. stock market is fairly valued--not overvalued or undervalued. Interest rates are rising. Volatility is present in the market.
As you read the case, try to identify any biases you see based on the fact pattern. When solving for the investment strategy, for simplicity reasons, assume that all client portfolio allocations will be divided among three asset classes: stocks, bonds, and cash.
When thinking about the case, remember that every advisory relationship is unique, and there is no absolute way to understand and respond to client behavior and biases. Keep this in mind while reading and thinking about how you might handle similar situations in your own way with clients. Focus most on applying methods of behavioral analysis, investment strategy, and solution proposal, and tailor your advisory approach to the given market and client situation.
Case Study: The Situation
This case involves a married couple. However, while analyzing the case, treat the couple as a single client; try to identify biases and the behavioral investor type as if they were a single individual.
The Masters family includes a financially informed, well-educated couple, both 43, and two children, ages 4 and 6. The family is financially sound, but their income has suffered recently during the current business and economic environment in Mr. Masters' industry: energy. The couple's total annual income is now $600,000, but that is down from an average of more than $ 1 million a year for more than 10 years straight. They own and manage an energy services company, but capital spending in the market segment they serve has fallen. At some point this should turn around, but they are uncertain as to how long that might take. In the meantime, they have valuable service contracts that provide steady and reliable cash flow to the business.
The Masters have saved $4 million. Mrs. Masters wants to buy an apartment in Manhattan. She has referred several times to how much money has been made on New York real estate. She believes that New York real estate will be a great investment. Their primary financial goals are, first, to be able fund their children's college educations, and second, to enjoy a comfortable early retirement, perhaps as early as age 55.
You have been working with the Masters for 10 years, starting your relationship just after the financial crisis of 2008. Mr. Masters tends to lead the meetings, but Mrs. Masters also participates actively. Back then, you prepared a financial plan for them and recommended an asset allocation that was in line with their risk profile: 70% equities, 25% bonds, and 5% cash. When you first started working with them, however, the Masters chose to be more conservative, with an allocation of 40% equities, 40% bonds, and 20% cash.
This more conservative allocation was chosen in part because the Masters thought there would be another financial crisis. They often brought you articles referencing the 2008 financial crisis and the high debt levels of companies. In those meetings, you pointed out that central-bank action could help repair the global economy and that economic trends were favorable. The Masters disagreed and remained pessimistic. As a result, they missed a wealth-building opportunity by not investing more heavily in equities when they were undervalued immediately after the crisis. They still believe another financial crisis is coming.
This couple is typically not receptive when you advise them to "stay on course" with their plan. They believe they are correct in their assessment of the current economic environment and do not plan to invest more aggressively until they are convinced the "coast is clear." You are concerned because you think that if they do not take more risk with their portfolio, they may not be able to meet their long-term goals.
Case Study: Analysis
Assume you are the Masters' advisor. Your job is to advise them on the best allocation you believe is appropriate for them given their unique circumstances and behavioral profile. You are trying to ensure that they feel comfortable enough with your investment solution that they will not decide to change it six months from now.
To help further analyze their situation and devise a plan, answer the following questions. In next month's article, we will review the answers to these questions and provide a suggested solution.
1) What behavioral biases might drive the Masters' behavior and decision-making? What specific evidence leads you to this diagnosis?
2) What is the couple's behavioral investor type?
3) How might their 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 for the couple?
6) How should you as the advisor facilitate the client conversation so that the Masters make a good and thoughtful investment decision and exhibit more-consistent investor behavior?
Previous installments in the series:
Why You Need to Understand Behavioral Investor Types
The Four Behavioral Investor Types
How Advisors Can Help Preservers and Followers Succeed
How Advisors Can Help Independents and Accumulators Succeed
Advising a Too-Conservative Retiree Using Behavioral Investor Types
How to Advise Preservers
Advising a High-Earning, Risk-Taking Pre-Retiree Using Behavioral Investor Types
How to Advise the Accumulator Investor Type
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. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients. Contact Michael at firstname.lastname@example.org.
The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.