This is the 11th 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 Tony Highsmith is a 29-year-old successful sales executive for a real estate company. He is single, relatively well-off (comes from an upper middle-class family, very well educated), and lives a high-spending lifestyle. He owns an expensive condo in downtown Boston, enjoys a healthy social life, and, although he spends aggressively, saves 20% of his income to invest for the long run. He recently got engaged to Chloe, age 28, who works as a dental assistant; they plan to start a family in the next few years, and Chloe will stay home to take care of the family. His near-term goal is that he wants to buy a house in the Boston suburbs with his fiancée and contribute to the cost of their wedding. Longer term, he wants to raise a family and retire at age 60.
His investment portfolio is aggressive--100% stocks. He began investing in 2011 and has seen nothing but a bull market. Since he has never been through a market cycle, he assumes this one will continue--and continues to invest in risky stocks. He started out investing in index exchange-traded funds such as SPDR S&P 500 ETF SPY but has moved on to buying individual technology stocks, such as Apple AAPL, Amazon.com AMZN, Facebook FB, Alphabet GOOG, and Netflix NFLX. His co-workers and friends are making a lot of money in these stocks, so he figures he should do the same. He thinks that if he does not invest in these stocks, he will regret it later. Tony has managed to save and invest $250,000.
Tony is not receptive when you tell him you think he should diversify his portfolio. You are concerned that Tony hasn’t been through any adversity in his career and is being naive about risk. You think that he could be setting himself up for failure in his short-term goal of saving for his wedding and house and, possibly, the important years of saving for college and meeting the longer-term goal of retiring early.
Case Study: Analysis Assume you are Tony's advisor. Your job is to advise him on the best allocation you believe is appropriate for him given his unique circumstances and behavioral profile. You are trying to ensure that he feels comfortable enough with your investment solution that he will not decide to change it six months from now.
To help further analyze Tony's 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 Tony's behavior and decision-making? What specific evidence leads you to this diagnosis?
2) What is his behavioral investor type?
3) How might 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 Tony?
6) How should you as the advisor facilitate the client conversation so that Tony makes a good and thoughtful investment decision and exhibits 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 Advising a Couple That Fears a Financial Crisis How to Analyze the Independent 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 email@example.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.