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Ambiguity Aversion (Cognitive) Friendly Followers prefer ambiguity-free options even when they are less likely to succeed than ambiguous choices. They choose investments based on the number of variables instead of the probabilities of high returns. Solution investing and are comfortable taking risks, but they can resist following a financial plan. Of all behavioral investor types, Independent Individualists are the most likely to be contrarian, which sometimes pays off. Biases resembles an earlier value stock that was a successful investment—but the new investment is actually not a value stock but a fallen growth stock. Self-Attribution (Cognitive) First and foremost, advisors should recognize that Friendly Followers overestimate their risk tolerance. Risky trend-following behavior occurs in part because Friendly Followers don’t like situations of ambiguity that may accompany the decision to enter an asset class when it is out of favor. They also may convince themselves that they “knew it all along” when an investment idea goes their way, which also increases future risk-taking behavior. Advisors need to handle Friendly Followers with care because they are likely to say yes too quickly and then regret their decision. Advisors should lead Friendly Followers to take a hard look at these behavioral tendencies that cause them to overestimate their risk tolerance. Because Friendly Follower biases are cognitive, education on the benefits of portfolio diversification and sticking to a long-term plan are effective. Advisors should back their recommendations with data. A steady, educational approach will generate client loyalty and adherence to investment plans. Independent Individualist biases are cognitive: conservatism, availability, confirmation, representativeness, and self-attribution. Conservatism (Cognitive) Independent Individualists tend to ascribe their investment successes to their innate talents and blame failures on outside influences. Therefore, they fail to learn from their mistakes, and they become overconfident in their investment savvy. Confirmation (Cognitive) Independent Individualists cling to a view or forecast at the expense of acknowledging new information. They tend to underreact in adverse investment situations. For example, assume an investor purchases a security based on knowledge about a forthcoming new product announcement. The company then announces that it is experiencing problems bringing the product to market. Independent Individualists might cling to the initial, optimistic impression of the new product announcement and fail to take action on the negative announcement. Availability (Cognitive) Independent Individualists observe, overvalue, and seek out information that confirms their claims, and they ignore or devalue evidence that might discount their claims. They often fail to acknowledge anything negative about their investments, leaving them blind to an imminent decline. Solution Independent Individualist Independent Individualists are active investors with medium-to-high risk tolerance who are strong-willed and independent thinkers. They are self-assured and “trust their guts” when making decisions; however, when they do their own research, they may not be thorough enough. Sometimes, Independent Individualists make investments without consulting their advisor. This can be problematic because these clients maintain their views even when market conditions change. Independent Individualists often enjoy Independent Individualists tend to estimate the probability of an outcome based on how prevalent that outcome appears in their lives. People exhibiting this bias perceive easily recalled possibilities as being more likely than those prospects that are harder to imagine or difficult to comprehend. As a result, Independent Individualists tend to base investment decisions on information available to them, such as advertising, suggestions from friends, the industry they work in, and where they live. Representativeness (Cognitive) Independent Individualists can be difficult clients to advise because of their independent mind-set, but they are usually grounded enough to listen to sound advice when it is presented in a way that respects their independent views. Collaborate with them, instead of directing them. Independent Individualists are firm in their belief in themselves and their decisions but can be blinded to contrary thinking. As with Friendly Followers, education is essential to changing behavior of Independent Individualists; their biases are predominantly cognitive. A good approach is to have regular educational discussions during client meetings. This way, the advisor doesn’t point out unique or recent failures but rather educates and incorporates concepts as appropriate. K Michael M. Pompian, CFA, CFP is an investment consultant and author of Behavioral Finance and Wealth Management (Wiley Finance, 2006). He also writes a monthly column on behavioral finance for MorningstarAdvisor.com. Representativeness bias occurs as a result of a flawed a perceptual framework when processing new information. To make new information easier to process, some investors project outcomes that resonate with their own pre-existing ideas. Independent Individualists might view a particular stock, for example, as a value stock because it MorningstarAdvisor.com 39

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Morningstar Advisor - October/November 2009

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