How to Advise the Follower Investor Type
Michael Pompian shares some strategies for overcoming this behavioral investor type's biases.
This is the twelfth 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 Tony Highsmith, a young sales executive. By way of refresher, here are some of the salient points about the case:
To better understand his situation, we are going to answer the following questions and then will provide a suggested solution to their situation.
1) What is his behavioral investor type?
2) What behavioral biases might drive his behavior and decision-making? What specific evidence leads you to this diagnosis?
3) How might Tony’s 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 Tony?
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
Tony’s biases are very consistent with a behavioral investor type. We know that he is a Follower because, based on the descriptions in the case study, he has the following biases:
Recency bias--A predisposition to recall and emphasize recent events and/or observations, and to extrapolate patterns where none exist.
Hindsight bias--Occurs when an investor perceives past investment outcomes as having been predictable.
Framing bias--The tendency of investors to respond to situations differently on the basis of the context in which a choice is presented (framed).
Cognitive Dissonance bias--Occurs when people believe something and persist in believing it--even when faced with evidence to the contrary--because they don’t want to acknowledge the discomfort of their beliefs being wrong.
Regret Aversion Bias--Avoiding taking decisive actions because of the fear that an investor might, in hindsight, regret whatever course he or she selects.
The Follower behavioral investor type leads investors to move toward risk even when they don’t have the risk tolerance to accept excessive risk. This is the case here, because Tony wants to be in the latest fad investments (FAANG); he is ignoring the risks. Tony’s recency bias (thinking that prosperity will last indefinitely) coupled with regret aversion (thinking he will regret not owning FAANG stocks) have caused him to be more risk-tolerant than he should be. In addition, he has cognitive dissonance bias, because he won’t accept the fact that there have been periods when tech stocks have done poorly.
It is up to you now to decide how to prepare a recommendation for Tony. You have been working with Tony for two years and your first recommendation for him was an asset allocation of 65% equities, 25% bonds, and 10% cash. He chose a more-aggressive allocation of 100% equities and no bonds or cash. You decide to meet him near the middle, suggesting an allocation that incorporates his financial goals while at the same time accounting for his biases. Therefore, you decide that a reasonable allocation is 75% equity, 10% cash, and 15% bonds. You call Tony to schedule a meeting to go over your recommendations. When you have the meeting, you decide that you will accomplish the following as it relates to explaining your recommendations and his reactions to them.
Michael M. Pompian, CFA, CAIA, CFP is an investment consultant to ultra-affluent clients and family offices, and is 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 him at firstname.lastname@example.org.
The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.
Previous installments in the series:
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
Advising a Couple That Fears a Financial Crisis
How to Analyze the Independent Investor Type
Advising a Young Risk-Taker
Michael Pompian does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.