Understand the biases when dealing with clients, before building an investment portfolio, and also chose your clients carefully.
With these words, international adviser and author Michael M Pompia, who was hosted by the Institute of Behavioural Finance (IBF), maintains that behavioural finance is an art and not a science, and judgment calls are needed, although he suggests that it’s important to have some form of framework, for advisers to work with.
Behavioural finance (BH) doesn’t only apply to the ultra rich, it applies to all clients. BH is not limited to any one size of investor, says Pompian who only advises the ultra rich in New York, and wont talk to people with less than $100m to invest.
He suggests that the adviser business is about relationships, and there is a misconception that sub par investment returns are the main reason that clients fire their advisers – not true – its because the adviser doesn’t have the ability or time to “get inside the head’ of their clients.
As a starting point he maintains that clients are split into two main categories – active and passive clients. Active clients will risk their capital to build wealth while the passive investor is someone who has inherited the wealth or is building wealth while employed in a steady job.
The importance of emotional biases cant be over-emphasised and he maintains that emotion plays an important role for either end of the behavioural investor types – the conservative and aggressive investor – who generally will make emotional decisions.
And just in case this appears to simplistic, be aware that clients may well change the behavioural investment types that they have been categorised as, over time.
In one of his international research studies he found that 98% of advisers were able to recognize behavioural biases in their clients, and added to which 98% of their clients made irrational investment decisions.
The trick then is also when to adapt the portfolio to suit the client’s biases and deciding when the client’s biases or behaviour should be adapted?
He suggests that the clients behavioural profile should be determined before a portfolio is developed, which will lead to a long-term and sustainable business relationship that will deliver performance above expectations – that elusive alpha.
The top 20
The top 20 irrational investor behaviours include: loss aversion, or ‘get-evenitis’, endowment bias, status quo bias, regret aversion, anchoring bias, mental accounting bias, recency bias, hindsight bias, framing bias, cognitive dissonance bias, ambiguity aversion bias, conservatism bias, availability bias, representativeness bias, self attribution bias, confirmation bias, overconfidence bias, illusion of control bias, self control bias, and optimism bias.
According to his international research findings, loss aversion, overconfidence and anchoring bias were the top three behaviours recognized by advisers when working with their clients. Based on some dipstick research in Johannesburg, it appears that loss aversion is also seen as the biggest behavioural bias.
When dealing with ultra affluent client – who are used to controlling every situation they are in, is a challenge – they walk into the practice thinking that they can treat the adviser is a way that they treat everyone else.
Wrong – the adviser needs to understand that at the beginning – stand your ground, within reason and without being offensive, understanding that a couple of months down the line the portfolio constructed has to be based on your principles and experience and not that of the ultra high net worth client – otherwise they will begin to wonder why they hired you in the first place.
The ideal number of clients is really about service levels. Service wins in the end – it is easy to take on clients when you shouldn’t. Take on good clients, he suggests and don’t take on every client – it is tempting, but there is more success in smaller numbers, and higher service levels.
Pompian suggest that it’s really about communication, conviction and a knowledge that you know that the right advice being offered.