How to Analyze the Independent Investor Type

This is the 10th article in a series focusing on behavioral investor types, and it is intended to help advisors strengthen their relationships with their clients by helping them better understand financial personalities. Once advisors understand the various investor types at play, they can adjust their advisory approach for each type. 

In last month's article, we reviewed the case of the Masters family, a high-net-worth couple. By way of refresher, here are some of the salient points about the case:

• The Masters family includes a financially informed, well-educated couple, both 43, and two children, ages 4 and 6.
• The couple's total annual income is now $600,000, but that is down from an average of more than $1 million annually for more than 10 consecutive years.
• They own and manage an energy-services company, but capital spending in the market segment they serve has fallen. 
• The Masters have saved $4 million.
• In addition to Mrs. Masters' desire to buy and apartment in Manhattan, their primary financial goals are to be able fund their children's college educations and to enjoy a comfortable early retirement, perhaps as early as age 55.
• You have been working with the Masters family for a decade, starting with them just after the financial crisis of 2008. Back then, you prepared a financial plan for them and recommended an asset allocation in line with their risk profile: 70% equities, 25% bonds, and 5% cash. 
• The Masters, however, chose to be more conservative: 40% equities, 40% bonds, and 20% cash. This more conservative allocation was chosen in part because the Masters thought there would be another financial crisis.
• The couple often brought articles to client meetings referencing high debt levels of companies and about the 2008 financial crisis. This behavior caused them to miss a wealth-building opportunity by not investing in equities more heavily immediately after the crisis when they were undervalued. They still believe another financial crisis is coming.
• This couple is typically not receptive when you advise them to "stay on course" with their plan. They believe they are correct in their assessment of the current economic environment and do not plan to invest more aggressively until they are convinced the "coast is clear."
• You are concerned because you think that if they do not take more risk with their portfolio, they may not be able to meet their long-term goals.

This case involves a married couple. However, while analyzing the case, treat them as a single client; try to identify biases and the behavioral investor type as if they were a single individual. To better understand their situation, we are going to answer the following questions and then will provide a suggested solution to their situation.

1) What is their behavioral investor type?

2) What behavioral biases might drive their behavior and decision-making? What specific evidence leads you to this diagnosis?

3) How might the Masters' personal biases affect the asset-allocation decision?

4) How should the advisor approach the client to moderate or adapt the impact of these biases?

5) What is a reasonable allocation recommendation for the Masters? 

6) How should you as the advisor facilitate the client conversation so that the client makes a good and thoughtful investment decision and shows more-consistent investor behavior?

Case Study: Answers to Questions
The Masters' biases are very consistent with an independent behavioral investor type. We know that they are independent because, based on the descriptions in the case study, they exhibit the following cognitive biases:

• Conservatism bias: When someone makes a forecast and clings to that forecast irrationally, even when presented with contrary information.
• Confirmation bias: Seeking information that confirms a pre-existing view rather than seeking information that may contradict a pre-existing view.
• Availability bias: The tendency to believe that what is easily recalled is more likely to happen.
• Representativeness: Letting pre-existing ideas unduly influence how new information is processed.
• Self-attribution: Ascribing success to innate talents and blaming failures on outside influences.

The independent behavioral investor type profile leads to a clear allocation preference for risk; typically, independents are risk-tolerant. In the case of the Masters, however, their availability bias (thinking that another crisis is near) coupled with conservatism bias (making a forecast and clinging to that forecast irrationally) have caused them to be more risk-averse. In addition, confirmation bias is reinforcing these views and preventing them from taking on a riskier allocation. 

It is up to you to decide how to prepare a recommendation for the Masters. You have been working with them for a long time and know them well. You reflect on when you started--back then, you prepared a financial plan recommending an asset allocation of 70% equities, 25% bonds, and 5% cash. They chose a more conservative allocation of 40% equities, 40% bonds, and 20% cash. They never did get to your target. You decide to "meet them near the middle" with an asset-allocation plan that takes into account the Masters' financial goals while at the same time accounts for their biases. Therefore, you decide that a reasonable allocation is 60% equities, 35% bonds, 10% cash.

When meeting with the Masters, you decide that you will accomplish the following as it relates to explaining your recommendations and their reactions to them:

• Listen--Seek to understand. Listen actively.
• Clarify--Confirm your understanding of the client's desires and ask clarifying questions to go deeper.
• Empathize--Summarize your understanding and demonstrate that you see the client's perspective. If appropriate, acknowledge the client's feeling about the topic.
• Explore--Rationally explore the alternatives to consider.
• Answer--When you make your recommendation explain why it is the rational choice. Connect the recommendation to the vision of the goal by inviting the client to "imagine" what success will feel like.
• Check--Check for agreement.

Previous installments in the series:

Advising a Couple That Fears a Financial Crisis
Why You Need to Understand Behavioral Investor Types
The Four Behavioral Investor Types
How Advisors Can Help Preservers and Followers Succeed
How Advisors Can Help Independents and Accumulators Succeed
Advising a Too-Conservative Retiree Using Behavioral Investor Types
How to Advise Preservers
Advising a High-Earning, Risk-Taking Pre-Retiree Using Behavioral Investor Types
How to Advise the Accumulator Investor Type

Michael M. Pompian, CFA, CAIA, CFP, is the founder and chief investment officer of Sunpointe Investments, an investment advisor to family offices based in St. Louis. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients. Contact Michael at michael@sunpointeinvestments.com.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.