Morningstar Advisor - October/November 2009 - 36

Spotlight Behavioral Alpha Classification Conservative Passive Moderate Active Aggressive Passive Preserver Emotional Endowment Loss Aversion Status Quo Anchoring Mental Accounting Friendly Follower Cognitive Ambiguity Aversion Hindsight Framing Cognitive Dissonance Recency Independent Individualist Active Accumulator Emotional Conservatism Availability Conﬁrmation Representativeness Self-Attribution Overconﬁdence Self-Control Optimism Illusion of Control Step 3: Identify Client’s Behavioral Investor Type and Biases If an investor is passive and has a very low risk tolerance, the investor likely has the biases associated with the Passive Preserver behavioral investor type. If the investor is passive and has a moderate risk tolerance, the investor likely has the biases associated with the Friendly Follower. An investor who is active and has a moderate risk tolerance likely has the biases associated with an Independent Individualist. Finally, if an investor is active and has an aggressive risk tolerance, the investor likely is an Active Accumulator. Some readers may be wondering whether one investor type might have biases that are associated with a different type. The answer is most certainly yes. Advisors should keep in mind, however, that their task isn’t necessarily to identify each and every bias a client has (although they could). Rather, the task is to correctly identify the client’s behavioral investor type and, most importantly, whether cognitive or emotional biases dominate. In the above figure, clients at either end of the scale are emotionally biased in their behavior, and clients in the middle are cognitively biased. This makes sense. Clients with a high need for security are emotionally driven; they get very emotional about losing money and very uneasy during times of stress or change. Similarly, very aggressive investors also are emotional. They typically suffer from overconfidence and mistakenly believe they can control their investment outcomes. In between are the investors who mainly suffer cognitive biases and need education and information to make better investment decisions. But of primary importance to advisors is the fact that clients who are emotional investors need to be advised differently than those who make mostly cognitive errors. When advising emotional investors, advisors must focus on how the investment program affects important emotional issues such as financial security, retirement, and future generations, not quantitative details such as standard deviations and Sharpe ratios. The quantitative approach is more effective with clients who are less emotional and make cognitive errors. Step 4: Tailor Advice to Client’s Behavioral Investor Type and I offer suggestions of how advisors should advise each type of client. Advisors who wish to dive deeper into this process may want to determine exactly which biases a client has. Diagnosis requires extensive testing. One of the benefits of the top-down Behavioral Alpha approach is that instead of testing a client on 20 (or more) investment biases, advisors can test only on the biases associated with their investor type. My book, Behavioral Finance and Wealth Management, contains questions designed to detect each investment bias. Passive Preserver Passive Preservers place great emphasis on financial security and preserving wealth. Many have gained wealth through inheritance or by working in a large company. Because they tend not to have risked their own capital, Passive Preservers may be financially unsophisticated. Some are worriers; they obsess over short-term performance and are slow to make investment decisions because they’re uncomfortable with change. This behavior is consistent with their approach to their professional lives; they are careful not to take excessive risks. After advisors have identified what behavioral investor type a client is, they can begin to deliver customized investment plans that consider the client’s biases. On the following pages, I briefly break down each investor type and its traits and biases, 36 Morningstar Advisor October/November 2009

Morningstar Advisor - October/November 2009

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2009