behavioural finance with private clients

8/13/2019 Behavioural Finance with Private Clients

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Using

Behavioral

Finance withPrivate Clients

Lesson 2


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First of all, lets view behavioral finance in the correct light.Advisors can benefit enormously from using behavioral finance in theirinvestment advisory work.

Some readers will be tempted to view behavioral finance as a newconcept, and may feel reluctant to accept its validity. On the con-trary, irrational behavior has existed for centuries.

Some may not feel comfortable asking their clients psychologicalor behavioral questions to ascertain biases, especially at the beginning of the advisory relationship. It is essential, however, that anadvisor overcome this discomfort.

In the coming years, behavioral finance will be a mainstream aspect of thewealth management relationship, for both advisors and clients. Why not getahead of the curve? The sooner we understand these concepts, the better offwe will be in the long run.

Lets review some benefits of applying behavioral finance.There is little doubt that an understanding of how investor psychology impactsindividual investor outcomes can benefit the advisory relationship.

A key result of a behavioral financeenhanced relationship will be an invest-ment program that the client can live with during up and down markets.

A client who understands her investor behaviorlearned by working with herfinancial advisorwill have a stronger relationship with her advisor. Thoughwealth management practitioners may differ in how they measure the success

of an advisory relationship, most agree that, aside from the monetary aspectsevery successful relationship shares at least four fundamental characteristics:

1. The clients financial goals are clearly understood by the financialadvisor.

2. The advisor uses a structured, consistent approach to advising theclient.

3. The advisor delivers what the client expects.4. The relationship benefits both client and advisor.

So, how can behavioral finance help?

Understanding the Psychology Behind a Clients Financial GoalsThe foundation of a successful advisor-client relationship is the clear definitioof financial goals. In addition to factors such as risk tolerance, return objec-tives, and tax situation, it is also essential to be aware of other, less technicalaspects of a clients financial situation.

It is important to understand the psychology and emotions underlying the decsions behind the financial goals. At times, financial advisors find themselves inthe role of a psychologistassessing what the clients motives and emotionsare when making financial decisions. In some cases, clients need to be savefrom the psychology behind their own poor decision making.

Using Behavioral Finance with Private Clients

KEY BENEFITS OF BEHAVIORAL FINANCE


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The better the advisor is at diagnosing a clients irrational behaviors prior tocreating an investment plan, the easier it is for him to create a plan that workfor the client. The methodology learned in this course should help financialadvisors develop stronger relationships with their clients and help them adher

to their long-term investment plans.Maintaining a Consistent ApproachMost successful advisors take a consistent approach to delivering wealth management services. Successful investing is a process and should not be treatedas a monthly or quarterly guess as to what investment will be in vogue.The principles of behavioral finance should become part of that discipline.Many successful financial advisors make sure that their clients get regularfeedback on their investment behavior. Each periodic meeting (for example,quarterly) involves a review of not only investment results, but also investmentrecommendations made by the advisor and by the client. This way, advisorscan accumulate a knowledge base of behavioral finance information for futurreference.

Once advisors have a foundation of knowledge in behavioral techniques,they will be able to consistently assess their clients behavior, which adds moreprofessionalism and structure to the relationship. Clients will appreciate thatyou have taken the time to understand them, and the relationship will likely bemore successful. In addition, clients will start to recognize their own irrationalbehaviors, which should make your job as the financial advisor easier.

Delivering What the Client ExpectsClients have two main expectations of their advisor:

1. An understanding of the clients objectives based on a needsassessment.

2. Investment returns that are consistent with their objectives (andother factors such as risk tolerance).

The best advisors are able to incorporate behavioral finance into these two keareas. If you take the time to understand your clients behaviors before youdesign an investment plan, the plan is more likely to be successful, becauseobjectives for the plan are clearer and returns are more likely to match theclients needs. Unfortunately, the opposite also applies; in many instances, theadvisor doesnt try to understand what drives the clients investment decisions,

and therefore fails to help the client reach her objectives. Make sure you arenot one of those financial advisors!

Ensuring Mutual BenefitsA happier, more satisfied client will strengthen the advisors practice andenhance the advisors work life. A client who is happy and satisfied will havefinancial security and confidence and will likely not seek the services of a competing advisor.




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When both the client and the advisor have benefited, a strong relationship isusually the result. Incorporating insights from behavioral finance into the ad-visory relationship will enhance that relationship, and will lead to more fruitfuresults for both client and advisor.

It is well known by those in the individual investor advisory business that aver-age or even slightly below-average investment results are often not the primareason that a client seeks a new advisor (although extremely poor returns arecause for major concern).

The number one reason that investment practitioners lose clients is that theclient does not feel the advisor understands, or tries to understand, the clientfinancial objectives, and the inevitable result is a poor relationship.

The primary benefit of behavioral finance is that it can help develop a strong

bond between client and advisor, both at the beginning of and throughout anadvisory relationship. By understanding the client and developing a compre-hensive grasp of his motivations and fears, the advisor can help the client tobetter understand the reasons for a portfolios design, and why it is the rightportfolio for himregardless of what happens in the day-to-day markets.

In summary, by understanding behavioral finance, advisors can build stron-ger relationships with their clients. This not only helps the client to achieve hisfinancial goals, but also helps the advisor develop a stronger, more vibrantpractice, which makes for a more satisfying career.

LIMITATIONS OF RISK TOLERANCE QUESTIONNAIRESIndividual investors get financial advice from many types of firms, includingdo-it-yourself financial service firms, full-service brokerage firms, banks, andinternet-based firms.

In an attempt to standardize asset allocation processes and comply with suit-ability rules, most large financial service firms require their advisors to adminiter risk tolerance questionnaires to clients (and potential clients) prior to mak-ing investment recommendations. This process is certainly useful and generatimportant information (such as the maximum amount of loss a client cantolerate, the investment time horizon, the primary investment objective of the

client, and general attitudes about risk). However, it is important to recognizethe limitations of risk tolerance questionnaires.

From the behavioral finance perspective, risk tolerance questionnaires maywork well for institutional investors, but often fail when applied to psychologi-cally biased individuals.

A prime example of a failure to properly assess an individual investors risktolerance is the scenario in which a client, in response to short-term marketfluctuations, demands that her asset allocation be changed. Moving repeatedin and out of an allocation can cause serious long-term negative consequenc

es to a portfolio.




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Panic selling is often considered to be a buying opportunity for behaviorallyaware investors. Behavioral biases should be identified before the allocation iexecuted so that such problems can be avoided.

As a financial advisor, you should constantly remind your clients not to aban-don a well-crafted asset allocation during down periods and to hold on towinners too long during up periods without rebalancing. Many clients havean innate desire to hold on to losing investments and sell winners too quickly.Over time, you will be able to help clients recognize these behaviors for themselves.

In addition to ignoring behavioral issues, risk tolerance questionnaires cangenerate different results when administered in slightly varying formats to thesame individual investor. The differences are usually a result of how the ques-tions are worded (we will look at an example of this shortly). Further, most risk

tolerance questionnaires are administered once, at the beginning of a rela-tionship, and are not revisited. As we can imagine, risk tolerances can varythroughout a persons life. Advisors should update their files to keep risk tolerance information current.

Another critical issue is that many advisors interpret the results of risk toler-ance questionnaires too literally. For example, a client might indicate that themaximum loss he is willing to tolerate in a single year is 20 percent of his totaassets, but this does not mean that an ideal portfolio would place this clientin a position to lose 20 percent. Advisors should set portfolio parameters thatpreclude a client from incurring the maximum specified tolerable loss in any

given period.

For these reasons, a risk tolerance questionnaire should be considered only aguideline for asset allocation, and should be used in concert with behavioralassessment tools.

SOMETHING TO CONSIDER -Framing Bias and Risk Tolerance QuestionnairesWhen administering risk tolerance questionnaires, framing bias is commonlyat work. Lets see how this works.

Suppose that a questionnaire refers to a hypothetical securities fundcalled Fund A. Over a 10-year period, Fund A has returned an annuaaverage of 12%, with a standard deviation of 15%.

Recall that standard deviation quantifies the amount of expected variation in an investments performance from year to year based on historcal data. The expectation is that 67% of As returns will fall within onestandard deviation of the mean, or annual average return of 12%.Similarly, 95% of returns will fall within two standard deviations, and99.7% within three standard deviations of the mean.


Limitations of Risk Tolerance Questionnaires


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So, if As mean return was 12%, and its standard deviation was 15%,then two-thirds of all returns produced by A would equal 12%, plus orminus 15%that is, 67% of the time we expect that Fund A will returnsomewhere between 3% to 27%. It follows that 95% of As returns wil

fall between -18% and 42%, and 99.7% will fall somewhere between33% and 57%.

Now, imagine that one (but not both) of the following questions appears on ainvestors risk tolerance questionnaire. Both concern Fund A, and both try tomeasure an investors comfort level with A, given its average returns and volatility. However, the two questions frame the situation differently. As you compaQuestion 1 and Question 2, think about how a client who may be subject tocommon behavioral biases might respond to each question. Would the clientanswers be identical in each instance below?

Question 1Based on the chart in Figure 1, which investment fund seems like the best fit you based on your risk tolerance as well as your desire for long-term return?

Figure 1 Sample Funds for Risk Tolerance Questionnaire

PortfolioName

95%Probability Gain/ Loss Range

Long-Term Return

B 3% to 5% 4%

C -7% to 17% 7%

A -18% to 42% 12%

A) Fund B

B) Fund C

C) Fund A




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Now consider question 2. Ignore question 1 while doing so.

Question 2

Lets assume you are contemplating investing money in Fund A. Based on

past performance, the managers of Fund A expect that two-thirds of thetime Fund A will earn between 27% and 3%. They also believe that thereis a small chance that it might earn less than 3% in some years. Will youinvest in A?

A) Yes, I will invest in A because I am comfortable with the risk level

B) I might Invest in A, but I want to know more about the risk level

C) No, I wont invest in A because I dont want such a wide range ofreturns

When describing risk, many financial advisors use one standard deviation asthe measure of risk. Many dont explain two or three standard deviations.A person may select similar answers for both questions, but there is also agood chance that an investor will answer these two questions differently.

Specifically, respondents might reject Fund A in question 1, yet when faced wiquestion 2, might decide to proceed with A.

In question 1, 95% Probable Gain/Loss Range refers to two standard deviations above and below the mean.

In question 2, the reader contemplates a return of one standard deviation.Because question 2 employs one standard deviation rather than two, readersare less likely to consider the one-third of all cases in which A could lose morthan 5% of its value (entering into the 95%, rather than the 67%, probablegain/loss range).

Here, the implications of framing are important. Inconsistentresponses to the questions above could render the questionnairineffective; an inaccurate measure of investor risk tolerance.Practitioners should be aware of how framing can affect theoutcome of various investment choices.




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Recognizing irrational behaviors in your clients is essential, but also challeng-ing. Once you are familiar with the more common behavioral biases, yourability to recognize and diagnose irrational behaviors will improve. Ultimately(as we will learn later in the course), your job is to adjust the clients asset

allocation to account for her irrational behaviors, so that she can be comfort-able with (and stick to) her chosen asset allocation, which will help her meether long-term financial goals.

There are two ways that advisors can diagnose irrational behaviors. To explainthe two ways, we will borrow from some relatively well-known investmentconcepts:

bottom-up top-down

From a bottom-up perspective, you first identify irrational behaviors and then

synthesize the information (as we will learn later) to create an asset allocationthat fits the client.

From a top-down perspective (the easier and recommended approach), we wplace clients into several categories before identifying their behavioral biases.Either way, we will arrive at the point where we are able to create a behavior-ally modified asset allocation for the client.

Bottom-upIn a bottom-up analysis, the advisor diagnoses behaviors (biases) either byquestionnaire or, once he knows enough about biases, by instinct. This courseis not long enough to provide diagnostics for each of the twenty most com-

mon biases. (To learn more about the bottom-up approach, read BehavioralFinance and Wealth Management which contains diagnostics on all twenty bi-ases and teaches how to apply this information to the asset allocation process

For illustration purposes, diagnostics are provided on two common biases:loss aversion and anchoring.

Diagnostic Testing - Loss Aversion BiasLoss aversion occurs when people feel the pain of losses more than the plea-sure of gains. A common unwritten rule has emerged that says that, on aver-age, avoiding losses is twice as powerful a motivator as the possibility of making a gain of equal magnitude.

Loss aversion can prevent people from unloading unprofitable investments,even when they see little or no prospect of a turnaround. Often, research intoa losing investment reveals a company whose prospects dont forecast a re-bound. Some industry veterans have coined a diagnosis, get-even-itis, to


Ways to Identify Irrational Behaviors in Your Clien


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describe investors who will not sell until they get even. However, loss-averseinvestors are indeed blinded by their desire to avoid losses.

The following series of questions are designed to detect loss aversion bias.

To complete the test, select the answer that best characterizes your clientsresponse to each item.

1. Suppose you make a plan to invest $5,000. You are pre-sented with two alternatives. You can either:

A. Get back $5,000 for sure, or

B. Have a 50% chance of getting $7,000 or a 50% chance of getting$3,500.

2. Suppose you make a plan to invest $7,000. You are pre-sented with two alternatives. You can either:

A. Get back $6,000 for sure, or

B. Take a 50-50 chance of getting back the original $7,000 or$5,000.

3. You are asked to choose between the following twooutcomes:

A. A sure gain of $475, or

B. A 25 % chance of gaining $2,000 and a 75 % chance of gainingnothing.

4. 4. You are asked to choose between the following twooutcomes:

A. A sure loss of $750, or

B. A 75 % chance of losing $1,000 and a 25 % chance of losingnothing.

Scoring Guidelines

1. Most people who are loss averse choose option A, despite B offering alarger potential return on the upside.

2. Question 2 is effectively the same question as 1, except for a differentstarting point, yet most investors change their choice and answer B.

The difference is due to peoples aversion to losses. Rather than admita loss in question 2, most investors are willing to take the chance of aneven greater loss. However, investors prefer the sure thing of breakingeven vs. the chance of a gain, in question 1.

3. Rational investors will choose option B, but loss-averse investors preferthe sure gain of A.

4. Again, the rational choice is A, yet loss-averse investors prefer B.

Once a diagnosis is made, the advisor takes inventory of not only the biases,but whether the biases are cognitive or emotional. This information is used toadjust an asset allocation (covered later in the course).

Investors exhibiting anchoring and adjustment bias are influenced by purchaspoints or arbitrary price levels, and tend to cling to these numbers when decid

ing whether to buy or sell a security or fund.




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This is especially true when new information about the security is introduced.In practice, when required to estimate a value with unknown magnitude, investors generally begin by envisioning some initial, default number, an anchorwhich they then adjust to reflect subsequent information and analysis. The fol-

lowing is a diagnostic for anchoring bias.

Diagnostic Testing - Anchoring Bias

1. Suppose you own a five-bedroom house and have decided that its time todownsize to a smaller townhouse that you have had your eye on for severa

years. You are not in a panic to sell your house, but your taxes are affect-

ing your monthly cash flow and you want to unload your house as soon a

possible.

Your real estate agent, whom you have known for many years, prices yourhome at $500,000 and you are thrilled, as you paid $125,000 10 years

ago. The house goes on the market, and no serious offers are made for

several months.

Then, your agent advises you that MortgageGrowth, a company that

moved into town five years ago at the height of the mortgage boom, has

just declared bankruptcy, and that 10,000 people are out of work as a

result. He tells you he has been in meetings all week with his colleagues

and they estimate that real estate prices are down about 10% across all

types of homes in your area. He says that you must decide your homes

list price based on this new information. You agree to think it over andget back to him.

Please select your response to your real estate agent:

A. You will keep your home on the market for $500,000

B. You will lower your price by 5% to $475,000

C. You will lower your price by 10% to $450,000

D. You will lower your price to $400,000 because you want to ensure

a bid on the house

Analysis A tendency toward either of the first two responses probably indicatesa susceptibility to anchoring and adjustment bias.

Remember: real estate prices have declined 10%. If the subject reallywants to sell her home, she must lower the price by at least 10%.Resistance to an adequate adjustment in price often stems from beinganchored to the $500,000 figure.

Anchoring bias impairs a persons ability to incorporate updated information.This behavior can have significant impact in the investment arena and should

be counselled extensively.




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There are three key steps to a top-down assessment of a clients investmentbehavior. The goal is that after the three steps, you will be able to classify theinvestor into a behavioral investor type, and can then adjust the asset allocatibased on your analysis of the clients behavior.

The three steps are:1. Identify active or passive traits.

2. Administer risk tolerance questionnaire.3. Classify into behavioral investor type and confirm behavioral

biases.

(Later on in the course, we will learn how to classify investors by their behavioinvestor type. For now, you simply need to learn the three steps of the top-dowapproach.)

Step 1: Interview client and identify active or passive traits

Most experienced financial advisors begin the financial planning process witha client interview, i.e., a question and answer session intended to gain anunderstanding as to the objectives, constraints, and past investing practices ofa client. Through this process an advisor should also try to assess whether aclient is an active or passive investor.

To determine whether an investor is passive or active, we turn to the excellentwork of Marilyn MacGruder Barnewall. In 1978, Barnewell classified investorby asking one basic question: did an investor risk his own financial assets tocreate his own wealth in his own lifetime? If so, he was active. If not, he waspassive.

It is important to understand the characteristics of active and passive inves-tors, because both types of investors have tendencies toward certain behaviorbiases. The following is a brief discussion of the characteristics of active andpassive investors.

Passive investorsAs defined by Marilyn Barnewall, passive investors:

are those investors who become wealthy by inheritance or by risking the capital of others such as stockholders, investors, or

taxpayers, to name a few usually have: a high need for security and

a low-to-moderate tolerance for risk.

Examples of passive investors include second or multi-generational inheritors,corporate executives, lawyers, accountants, politicians, and bankers.

Barnewall notes that passive investor is not a negative term; they can be, foinstance, CEOs of very dynamic corporations.


Top Down Approach


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Active investorsThese investors: earn wealth during their own lifetime have been actively involved in the wealth creation, and

have risked their own capital in achieving their wealth objectives have a higher tolerance for risk than they have need for security be

cause they believe in themselves prefer to maintain control of their own investments get very involved in their own investments and like to do du

diligence on contemplated investments and are often demanding clients

Lesson 3 presents a diagnostic test to help you assess whether a client is passor active.Step 2: Administer risk tolerance questionnaire

Once you have classified an investor as active or passive, you should administer a risk tolerance questionnaire to continue the process of identifying a clienBIT (behavioral investor type).

You should first confirm where the investor falls on the active-passive scale(see Chart 1 below) and match up the risk tolerance level of the client.

General Type


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When and if you have confirmed that a passive investor has a low risk toleranand an active investor has a high risk tolerance, you are ready to move todetermining the top-down behavioral investor type.

Step 3: Assess Behavioral Tendencies and DetermineBehavioral Investor Type

After you have determined active-passive status and administered a risktolerance questionnaire, you are ready to determine the clients behavioralinvestor type (BIT). BITs were designed to help an advisor make a speedy yetinsightful assessment of what type of investor his client is, and gain a quickunderstanding of what biases he should look for when encountering each BIT.

As we have learned, there are four BITs: the passive preserver (PP), the friendlfollower (FF), the independent individualist (II) and the active accumulator (AAEach BIT has unique associated biases (discussed in the next section).

Advisors should remember that BITs are not intended to be absolutes but,rather, guide posts when making the journey with a client.

For example, you may find that you have classified a client as a passivepreserver, but she has traits (biases) of a friendly follower or even anindependent individualist.

The grouping of investor biases into BITs provides advisors with clues as to

which biases may be present, i.e, what biases certain BITs tend to have.The goal of the advisor is to use BITs to discover irrational behaviors and thenultimately, to create a behaviorally-modified (best practical) asset allocationthat a client can comfortably adhere to to meet long-term financial goals.Chart 2 provides a preview of the next lessons, illustrating the biases associatwith each BIT, and the broad categories of bias (cognitive or emotional)associated with each BIT.

Chart 2: Spectrum of Behavioral Investor TypesOne interesting observation about Chart 2 is that the clients at either end of tpassive/active scale are emotional in their behavior. This should make intuitivsense.




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Passive preserver clients have a high need for security and want toprovide for their heirs. They behave this way because emotion drivesthis behavior. They get highly emotional about losing money and liketo maintain the status quo rather than making a lot of changes.

Likewise, highly aggressive investors, called active accumulators, arealso emotionally charged. They suffer from overconfidence and believethey can control the outcome of their investments.

In between these extremes, you have the friendly follower and theindependent individualist. These BITs both tend to exhibit cognitivebiases or faulty reasoning, but behave differently.

In the next lesson, well review the importance of BITs. After that (the next fourlessons) well review each BIT individually along with its behavioral biases.

1Barnewall, M. 1987. Psychological Characteristics of the Individual Investorin William Droms, ed. Asset Allocation for the Individual Investor.Charlottsville, Va: The Institute of Chartered Financial Analysts.



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