Guideline for practitioners before asset allocation
How to use behavioral biases in the process of consulting and investors' asset allocation
In our last blog post, Risk profiling through behavioral finance, we discussed behavioral biases affecting investors’ behavior when encountering volatile and unpredictable markets. Those behavioral biases also helped advisors to categorize the clients more precisely. This blog post will discuss different investor types and their particular biases. Then, we will provide some professional guidelines for practitioners to deal with the investors. By having this information, the advisor should give customized consultation for the client according to the behavioral biases and orientation.
As we discussed, we have four investor groups, each with its character and biases. Table 1. indicates the full view of these groups.
Generally, investors who are more emotional about their investment need to be advised differently from those who make mainly cognitive errors. The advisor should consider how an investment plan can affect essential emotional issues for emotionally driven investors rather than focusing on portfolio details like standard deviations and Shape ratios. In contrast, quantitative approaches are more practical and effective for investors with cognitive biases. In the following section, we will focus on these four investor types and their own primary biases.
Conservative investors (CIs) often emphasize preserving wealth. Many of them have gained their wealth without taking any risks. Frequent changes and uncertainty worry them and lead to a slow investment decision-making process. Many CIs focus on caring for family members and future generations, mainly by funding life-enhancing experiences such as education and homeownership.
Loss Aversion Bias
Loss aversion bias leads to a strong preference for avoiding losses rather than attaining gains. Thus, these clients tend to hold only losing investments too long, even when they see no prospect of a turnaround.
Status Quo Bias
Conservative investors prefer to maintain the same state as their current or previous investments. The status quo bias leads people to keep their financial situation as it currently is rather than risk improving their financial outlook.
Endowment bias occurs when people value their investment (such as a piece of real estate) more than one they neither possess nor have the potential to acquire.
Anchoring bias occurs when people make subsequent estimations and decisions based on an initial piece of information. Conservative investors are often influenced by purchase points and tend to hold their assets when they enter a downward market movement.
Mental Accounting Bias
Mental accounting bias occurs when people split their money mentally into different accounts. For example, investors might segregate their assets into safe and risky “buckets.” Although this behavior is usually not harmful, returns will almost certainly be suboptimal if all the assets are considered safe money.
Advice for Conservative Investors
CIs are challenging to advise because they are driven mainly by emotion. However, Advisors should take the time to interpret the behavioral signs provided by these clients. CIs need to know the “big-picture,” and advisors should not communicate with them in detail, such as standard deviations or Sharpe ratios. They should also be confident that their chosen portfolio will deliver the desired results and cover their emotional issues.
Moderate investors (MIs) often do not have their ideas about investing but instead follow their friends and colleagues in making investment decisions. They are comfortable with being invested in the latest, most popular investments, often without regard to a long-term plan. They often overestimate their risk tolerance, and advisors need to be careful not to suggest too many “hot” investment ideas because they will decide to invest in all of them. Often, they fear investing in financial markets and put off making investment decisions without professional advice. MIs generally comply with professional advice when they get it, but they can sometimes be difficult because they do not have an aptitude for the investment process.
Recency bias is a tendency to recall recent events, and observations are more important than past or future events. Moderate investors may invest when prices are peaking, materially hurting long-term returns.
Hindsight bias occurs when investors believe past events or investment outcomes are predictable. For example, in the financial crisis of 2008, many viewed the housing market’s performance from 2003 to 2007 as standard, only later saying, “Wasn’t it obvious?” when the market had a meltdown.
Framing bias is the tendency of investors to respond to situations differently based on the context in which a choice is presented (framed). The use of risk tolerance questionnaires provides a good example. Depending on how questions are asked, framing bias can cause investors to respond to risk tolerance questions in either a risk-averse or a risk-taking manner.
Cognitive Dissonance Bias
In psychology, cognitions represent attitudes, emotions, beliefs, or values. Cognitive bias is a state of mental discomfort that arises from holding multiple opposite beliefs simultaneously. Investors who suffer from this bias may continue to invest in a security or fund they already own after it has gone down, even when they know they should be judging the new purchase objectively and independently of the existing holding.
Regret Aversion Bias
Regret aversion bias leads investors to avoid taking decisive actions because they fear that, in hindsight, their decision will be a failure. Regret aversion can cause moderate investors to be too timid in their investment choices because of losses they have suffered in the past.
Advice for Moderate Investors
Advisers need to handle MIs with care because they will likely say yes to investment ideas that make sense to them regardless of whether the advice is in their best long-term interest. Advisers need to lead MIs to take a hard look at behavioral tendencies that may cause them to overestimate their risk tolerance. Because MI biases are mainly cognitive, educating MI clients on the benefits of portfolio diversification and sticking to a long-term plan is usually the best course of action. Offering information to MI clients in clear, unambiguous ways so they have the chance to “get it” is a good idea.
Growth investors (GIs) are active investors with a medium to high-risk tolerance. GIs are often self-assured and “trust their gut” when making decisions. However, when they do their research, they may not be thorough enough with due diligence tasks. GIs sometimes make investments without consulting anyone. This behavior can be problematic because, owing to their independent mindsets, these clients maintain their views even when those views are no longer supportable. GIs enjoy investing and are comfortable taking risks but may resist following a financial plan. GIs are the most likely to be contrarian of all the behavioral investor types, which can sometimes benefit them. Some GIs are obsessed with beating the market and may hold concentrated portfolios.
Conservatism bias occurs when people maintain one’s previous views or forecasts by insufficiently including new contradicting information. For example, assume that an investor purchases security based on knowledge about a forthcoming new-product announcement. The company then announces that it is experiencing problems bringing the product to market. GIs may cling to the initial, optimistic impression of the new-product announcement and fail to take action on the negative announcement.
Availability bias is the likelihood of an outcome or the significance of an event that depends on the ease of recalling information. For example, suppose the investors are asked to identify the “best” mutual funds. Many of them would perform a Google search and find funds from firms that engage in heavy advertising. As a result, they pick funds from such companies, although some of the best-performing funds advertise very little.
Representativeness bias is a desire to categorize new information based on previous experiences and classifications. For example, an investor might view a particular stock as a value stock because it resembles an earlier value stock that was a successful investment.
Self-attribution bias (or self-enhancing bias) refers to the tendency of people to link their successes to their innate talents and to blame failures on outside influences.
Confirmation bias occurs when people overvalue or actively seek information that confirms their previous beliefs while devaluing evidence that discounts their claims.
Advice for Growth Investors
GIs can be difficult clients to advise due to their independent mindsets. Still, they are usually grounded enough to listen to sound advice when presented in a way that respects their independent views. As we have learned, GIs firmly believe in themselves and their decisions but can be blind to contrary thinking. Education is essential to changing the behavior of GIs, whose biases are predominantly cognitive. A good approach is to have regular educational discussions during client meetings, in which the adviser does not point out unique or recent failures but rather educates clients and incorporates concepts that are appropriate for them. Advisers should challenge GIs to reflect on how they make investment decisions and should provide data-backed substantiation for their recommendations. Offering information in clear, unambiguous ways is a practical approach.
Aggressive investors (AIs) are often the first generation in their families to create wealth. Very wealthy AIs have often been in control of the outcomes of their business activities. They believe they can do the same with investing. AIs often like to change their portfolios as market conditions change, which often drops the investment performance. AIs are quick decision-makers; they may chase higher-risk investments that their friends or associates are investing in. Some AIs do not believe in such basic investment principles as diversification and asset allocation.
Overconfidence is best described as unwarranted faith in one’s thoughts and abilities, which contains cognitive and emotional elements. It occurs when people place unjustified trust in their abilities.
Self-control bias is the tendency to consume today at the expense of saving for tomorrow. This leads to opting for short-term satisfaction rather than focusing on long-term aims. For example, an aggressive client has high current spending needs, and suddenly the financial markets hit severe turbulence. The client may be forced to sell solid long-term investments that have been priced down owing to current market conditions.
Affinity bias refers to investors’ tendency to make irrationally uneconomical choices or investment decisions based on how they believe a certain product or service will reflect their values.
This bias occurs when investors focus on the outcome of a process rather than on the process used to attain the outcome. In the investment realm, this behavior focuses on a return outcome without regard to the process used to achieve the return.
The illusion of Control Bias
The illusion of control bias occurs when people believe that they can control or at least influence investment outcomes when, in fact, they cannot. For example, aggressive investors, who accept high levels of risk, believe that they can control their investments’ outcomes better than they do because they are “pulling the trigger” on each decision.
Advice for Aggressive Investors
Aggressive investors are the most difficult clients to advise, particularly if they have experienced losses. Because they like to control or at least get deeply involved in the details of the investment decision-making process, they tend to reject advice that might keep their risk tolerance in check. Furthermore, they are excited and optimistic that their investments will do well, even if that optimism is irrational. The best approach to dealing with these clients is to take control of the situation. Advisers who let an aggressive client dictate the terms of the advisory engagement will always be at the mercy of the client’s irrational decision-making, and the result will likely be an unhappy client and an unhappy adviser.
Michael M. Pompian (2012). Behavioral Finance and Investor Types: Managing Behavior to Make Better Investment Decisions. Wiley Finance.