Using Behavioral Finance with Private Clients

Lesson 2

Using Behavioral Finance with Private Clients

KEY BENEFITS OF BEHAVIORAL FINANCE
First of all, lets view behavioral finance in the correct light. Advisors can benefit enormously from using behavioral finance in their investment advisory work. Some readers will be tempted to view behavioral finance as a new concept, 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 psychological or behavioral questions to ascertain biases, especially at the begin- ning of the advisory relationship. It is essential, however, that an advisor overcome this discomfort.

In the coming years, behavioral finance will be a mainstream aspect of the wealth management relationship, for both advisors and clients. Why not get ahead of the curve? The sooner we understand these concepts, the better off we 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 impacts individual investor outcomes can benefit the advisory relationship. A key result of a behavioral financeenhanced relationship will be an investment program that the client can live with during up and down markets. A client who understands her investor behaviorlearned by working with her financial advisorwill have a stronger relationship with her advisor. Though wealth management practitioners may differ in how they measure the success of an advisory relationship, most agree that, aside from the monetary aspects, every successful relationship shares at least four fundamental characteristics: 1. The clients financial goals are clearly understood by the financial advisor. 2. The advisor uses a structured, consistent approach to advising the client. 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 Goals The foundation of a successful advisor-client relationship is the clear definition of financial goals. In addition to factors such as risk tolerance, return objectives, and tax situation, it is also essential to be aware of other, less technical aspects of a clients financial situation. It is important to understand the psychology and emotions underlying the decisions behind the financial goals. At times, financial advisors find themselves in the role of a psychologistassessing what the clients motives and emotions are when making financial decisions. In some cases, clients need to be saved from the psychology behind their own poor decision making.
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Using Behavioral Finance with Private Clients

KEY BENEFITS OF BEHAVIORAL FINANCE
The better the advisor is at diagnosing a clients irrational behaviors prior to creating an investment plan, the easier it is for him to create a plan that works for the client. The methodology learned in this course should help financial advisors develop stronger relationships with their clients and help them adhere to their long-term investment plans. Maintaining a Consistent Approach Most successful advisors take a consistent approach to delivering wealth management services. Successful investing is a process and should not be treated as 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 regular feedback on their investment behavior. Each periodic meeting (for example, quarterly) involves a review of not only investment results, but also investment recommendations made by the advisor and by the client. This way, advisors can accumulate a knowledge base of behavioral finance information for future reference. Once advisors have a foundation of knowledge in behavioral techniques, they will be able to consistently assess their clients behavior, which adds more professionalism and structure to the relationship. Clients will appreciate that you have taken the time to understand them, and the relationship will likely be more successful. In addition, clients will start to recognize their own irrational behaviors, which should make your job as the financial advisor easier. Delivering What the Client Expects Clients have two main expectations of their advisor: 1. An understanding of the clients objectives based on a needs assessment. 2. Investment returns that are consistent with their objectives (and other factors such as risk tolerance). The best advisors are able to incorporate behavioral finance into these two key areas. If you take the time to understand your clients behaviors before you design an investment plan, the plan is more likely to be successful, because objectives for the plan are clearer and returns are more likely to match the clients needs. Unfortunately, the opposite also applies; in many instances, the advisor doesnt try to understand what drives the clients investment decisions, and therefore fails to help the client reach her objectives. Make sure you are not one of those financial advisors! Ensuring Mutual Benefits A happier, more satisfied client will strengthen the advisors practice and enhance the advisors work life. A client who is happy and satisfied will have financial security and confidence and will likely not seek the services of a competing advisor.

Using Behavioral Finance with Private Clients

KEY BENEFITS OF BEHAVIORAL FINANCE
When both the client and the advisor have benefited, a strong relationship is usually the result. Incorporating insights from behavioral finance into the advisory relationship will enhance that relationship, and will lead to more fruitful results for both client and advisor.

It is well known by those in the individual investor advisory business that average or even slightly below-average investment results are often not the primary reason that a client seeks a new advisor (although extremely poor returns are cause for major concern).
The number one reason that investment practitioners lose clients is that the client does not feel the advisor understands, or tries to understand, the clients financial 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 an advisory relationship. By understanding the client and developing a comprehensive grasp of his motivations and fears, the advisor can help the client to better understand the reasons for a portfolios design, and why it is the right portfolio for himregardless of what happens in the day-to-day markets. In summary, by understanding behavioral finance, advisors can build stronger relationships with their clients. This not only helps the client to achieve his financial goals, but also helps the advisor develop a stronger, more vibrant practice, which makes for a more satisfying career. LIMITATIONS OF RISK TOLERANCE QUESTIONNAIRES Individual investors get financial advice from many types of firms, including do-it-yourself financial service firms, full-service brokerage firms, banks, and internet-based firms. In an attempt to standardize asset allocation processes and comply with suitability rules, most large financial service firms require their advisors to administer risk tolerance questionnaires to clients (and potential clients) prior to making investment recommendations. This process is certainly useful and generates important information (such as the maximum amount of loss a client can tolerate, the investment time horizon, the primary investment objective of the client, and general attitudes about risk). However, it is important to recognize the limitations of risk tolerance questionnaires. From the behavioral finance perspective, risk tolerance questionnaires may work well for institutional investors, but often fail when applied to psychologically biased individuals. A prime example of a failure to properly assess an individual investors risk tolerance is the scenario in which a client, in response to short-term market fluctuations, demands that her asset allocation be changed. Moving repeatedly in and out of an allocation can cause serious long-term negative consequences to a portfolio.
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Using Behavioral Finance with Private Clients

Limitations of Risk Tolerance Questionnaires
Panic selling is often considered to be a buying opportunity for behaviorally aware investors. Behavioral biases should be identified before the allocation is executed so that such problems can be avoided. As a financial advisor, you should constantly remind your clients not to abandon a well-crafted asset allocation during down periods and to hold on to winners too long during up periods without rebalancing. Many clients have an 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 can generate different results when administered in slightly varying formats to the same individual investor. The differences are usually a result of how the questions are worded (we will look at an example of this shortly). Further, most risk tolerance questionnaires are administered once, at the beginning of a relationship, and are not revisited. As we can imagine, risk tolerances can vary throughout 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 tolerance questionnaires too literally. For example, a client might indicate that the maximum loss he is willing to tolerate in a single year is 20 percent of his total assets, but this does not mean that an ideal portfolio would place this client in a position to lose 20 percent. Advisors should set portfolio parameters that preclude a client from incurring the maximum specified tolerable loss in any given period. For these reasons, a risk tolerance questionnaire should be considered only a guideline for asset allocation, and should be used in concert with behavioral assessment tools. SOMETHING TO CONSIDER Framing Bias and Risk Tolerance Questionnaires When administering risk tolerance questionnaires, framing bias is commonly at work. Lets see how this works. Suppose that a questionnaire refers to a hypothetical securities fund called Fund A. Over a 10-year period, Fund A has returned an annual average of 12%, with a standard deviation of 15%. Recall that standard deviation quantifies the amount of expected varia- tion in an investments performance from year to year based on histori- cal data. The expectation is that 67% of As returns will fall within one standard deviation of the mean, or annual average return of 12%. Similarly, 95% of returns will fall within two standard deviations, and 99.7% within three standard deviations of the mean.
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Using Behavioral Finance with Private Clients

Limitations of Risk Tolerance Questionnaires
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 or minus 15%that is, 67% of the time we expect that Fund A will return somewhere between 3% to 27%. It follows that 95% of As returns will fall between -18% and 42%, and 99.7% will fall somewhere between 33% and 57%.

Now, imagine that one (but not both) of the following questions appears on an investors risk tolerance questionnaire. Both concern Fund A, and both try to measure an investors comfort level with A, given its average returns and volatility. However, the two questions frame the situation differently. As you compare Question 1 and Question 2, think about how a client who may be subject to common behavioral biases might respond to each question. Would the clients answers be identical in each instance below? Question 1 Based on the chart in Figure 1, which investment fund seems like the best fit for you based on your risk tolerance as well as your desire for long-term return? Figure 1 Sample Funds for Risk Tolerance Questionnaire
Portfolio Name 95% Probability Gain/ Loss Range 3% to 5% -7% to 17% -18% to 42% Long-Term Return

B C A A) B) C) Fund B Fund C Fund A

4% 7% 12%

Using Behavioral Finance with Private Clients

Limitations of Risk Tolerance Questionnaires
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 the time Fund A will earn between 27% and 3%. They also believe that there is a small chance that it might earn less than 3% in some years. Will you invest in A? A) B) C) Yes, I will invest in A because I am comfortable with the risk level I might Invest in A, but I want to know more about the risk level No, I wont invest in A because I dont want such a wide range of returns

When describing risk, many financial advisors use one standard deviation as the measure of risk. Many dont explain two or three standard deviations. A person may select similar answers for both questions, but there is also a good chance that an investor will answer these two questions differently. Specifically, respondents might reject Fund A in question 1, yet when faced with question 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, readers are less likely to consider the one-third of all cases in which A could lose more than 5% of its value (entering into the 95%, rather than the 67%, probable gain/loss range). Here, the implications of framing are important. Inconsistent responses to the questions above could render the questionnaire ineffective; an inaccurate measure of investor risk tolerance. Practitioners should be aware of how framing can affect the outcome of various investment choices.

Using Behavioral Finance with Private Clients

Ways to Identify Irrational Behaviors in Your Clients
Recognizing irrational behaviors in your clients is essential, but also challenging. Once you are familiar with the more common behavioral biases, your ability 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 comfortable with (and stick to) her chosen asset allocation, which will help her meet her long-term financial goals. There are two ways that advisors can diagnose irrational behaviors. To explain the two ways, we will borrow from some relatively well-known investment concepts: 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 allocation that fits the client. From a top-down perspective (the easier and recommended approach), we will place clients into several categories before identifying their behavioral biases. Either way, we will arrive at the point where we are able to create a behaviorally modified asset allocation for the client. Bottom-up In a bottom-up analysis, the advisor diagnoses behaviors (biases) either by questionnaire or, once he knows enough about biases, by instinct. This course is not long enough to provide diagnostics for each of the twenty most common biases. (To learn more about the bottom-up approach, read Behavioral Finance and Wealth Management which contains diagnostics on all twenty biases 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 Bias Loss aversion occurs when people feel the pain of losses more than the pleasure of gains. A common unwritten rule has emerged that says that, on average, 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 into a losing investment reveals a company whose prospects dont forecast a rebound. Some industry veterans have coined a diagnosis, get-even-itis, to

Using Behavioral Finance with Private Clients

Ways to Identify Irrational Behaviors in Your Clients
describe investors who will not sell until they get even. However, loss-averse investors 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 clients response to each item.
1. Suppose you make a plan to invest $5,000. You are presented 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. Suppose you make a plan to invest $7,000. You are presented 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. You are asked to choose between the following two outcomes: A. B. 4. A sure gain of $475, or A 25 % chance of gaining $2,000 and a 75 % chance of gaining nothing. 4. You are asked to choose between the following two outcomes: A. A sure loss of $750, or B. A 75 % chance of losing $1,000 and a 25 % chance of losing nothing.

2.

3.

Scoring Guidelines
1. 2. Most people who are loss averse choose option A, despite B offering a larger potential return on the upside. Question 2 is effectively the same question as 1, except for a different starting point, yet most investors change their choice and answer B. The difference is due to peoples aversion to losses. Rather than admit a loss in question 2, most investors are willing to take the chance of an even greater loss. However, investors prefer the sure thing of breaking even vs. the chance of a gain, in question 1. Rational investors will choose option B, but loss-averse investors prefer the sure gain of A. Again, the rational choice is A, yet loss-averse investors prefer B.

3. 4.

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 to adjust an asset allocation (covered later in the course). Investors exhibiting anchoring and adjustment bias are influenced by purchase points or arbitrary price levels, and tend to cling to these numbers when deciding whether to buy or sell a security or fund.
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Using Behavioral Finance with Private Clients

Ways to Identify Irrational Behaviors in Your Clients
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 anchor, which they then adjust to reflect subsequent information and analysis. The following is a diagnostic for anchoring bias. Diagnostic Testing - Anchoring Bias 1.
Suppose you own a five-bedroom house and have decided that its time to downsize to a smaller townhouse that you have had your eye on for several years. You are not in a panic to sell your house, but your taxes are affecting your monthly cash flow and you want to unload your house as soon as possible. Your real estate agent, whom you have known for many years, prices your home 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 and get 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. C. D. You will lower your price by 5% to $475,000 You will lower your price by 10% to $450,000 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 indicates a susceptibility to anchoring and adjustment bias. Remember: real estate prices have declined 10%. If the subject really wants to sell her home, she must lower the price by at least 10%. Resistance to an adequate adjustment in price often stems from being anchored 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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Using Behavioral Finance with Private Clients

Top Down Approach
There are three key steps to a top-down assessment of a clients investment behavior. The goal is that after the three steps, you will be able to classify the investor into a behavioral investor type, and can then adjust the asset allocation based 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 behavioral investor type. For now, you simply need to learn the three steps of the top-down approach.) Step 1: Interview client and identify active or passive traits Most experienced financial advisors begin the financial planning process with a client interview, i.e., a question and answer session intended to gain an understanding as to the objectives, constraints, and past investing practices of a client. Through this process an advisor should also try to assess whether a client is an active or passive investor. To determine whether an investor is passive or active, we turn to the excellent work of Marilyn MacGruder Barnewall. In 1978, Barnewell classified investors by asking one basic question: did an investor risk his own financial assets to create his own wealth in his own lifetime? If so, he was active. If not, he was passive. It is important to understand the characteristics of active and passive investors, because both types of investors have tendencies toward certain behavioral biases. The following is a brief discussion of the characteristics of active and passive investors. Passive investors As 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, for instance, CEOs of very dynamic corporations.

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Using Behavioral Finance with Private Clients

KEY BENEFITS OF BEHAVIORAL FINANCE
Active investors These 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 due diligence on contemplated investments and are often demanding clients Lesson 3 presents a diagnostic test to help you assess whether a client is passive or 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 clients BIT (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 PASSIVE ACTIVE

<================================================||==============================================> Risk Tolerance Low Medium High

Chart 1: Active-Passive Scale

The purpose of the chart is to confirm the expectation that passive investors have a low-to-medium risk tolerance while active investors have a medium-tohigh risk tolerance. If an investor is passive, and the risk tolerance questionnaire reveals a very low risk tolerance, you are likely to have a passive preserver. If the investor is passive and the questionnaire reveals a low-to- medium risk tolerance, you are likely to have a friendly follower. If an investor is active and has a medium-to-high risk tolerance, you are likely to have an independent individualist. Finally, if an investor is active and has a high risk tolerance, you are likely to have an active accumulator. If the result is a contradiction between the scale and the questionnaire (say, a passive client with a high risk tolerance), you are encouraged to accept the risk tolerance questionnaire over the active-passive analysis.
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Using Behavioral Finance with Private Clients

KEY BENEFITS OF BEHAVIORAL FINANCE
When and if you have confirmed that a passive investor has a low risk tolerance and an active investor has a high risk tolerance, you are ready to move to determining the top-down behavioral investor type. Step 3: Assess Behavioral Tendencies and Determine Behavioral Investor Type After you have determined active-passive status and administered a risk tolerance questionnaire, you are ready to determine the clients behavioral investor type (BIT). BITs were designed to help an advisor make a speedy yet insightful assessment of what type of investor his client is, and gain a quick understanding of what biases he should look for when encountering each BIT. As we have learned, there are four BITs: the passive preserver (PP), the friendly follower (FF), the independent individualist (II) and the active accumulator (AA). Each 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 passive preserver, but she has traits (biases) of a friendly follower or even an independent 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 then, ultimately, to create a behaviorally-modified (best practical) asset allocation that a client can comfortably adhere to to meet long-term financial goals. Chart 2 provides a preview of the next lessons, illustrating the biases associated with each BIT, and the broad categories of bias (cognitive or emotional) associated with each BIT.

Chart 2: Spectrum of Behavioral Investor Types

One interesting observation about Chart 2 is that the clients at either end of the passive/active scale are emotional in their behavior. This should make intuitive sense.

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Using Behavioral Finance with Private Clients

KEY BENEFITS OF BEHAVIORAL FINANCE
Passive preserver clients have a high need for security and want to provide for their heirs. They behave this way because emotion drives this behavior. They get highly emotional about losing money and like to maintain the status quo rather than making a lot of changes.

Likewise, highly aggressive investors, called active accumulators, are also emotionally charged. They suffer from overconfidence and believe they can control the outcome of their investments. In between these extremes, you have the friendly follower and the independent individualist. These BITs both tend to exhibit cognitive biases or faulty reasoning, but behave differently.

In the next lesson, well review the importance of BITs. After that (the next four lessons) well review each BIT individually along with its behavioral biases.
1Barnewall,

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

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