In my book, “The Only Guide You’ll Ever Need for the Right Financial Plan,” there’s a detailed discussion on how investors can choose the right asset allocation for them, with the focus being on determining one’s ability (capacity), willingness (tolerance) and need (the rate of return required to achieve a goal) to take risk.
To help with issues surrounding the willingness to take risk, risk tolerance questionnaires have become a very popular. Unfortunately, as Joachim Klement showed in his article, “Investor Risk Profiling: An Overview,” published in the June 2018 CFA Institute Research Foundation brief “Risk Profiling and Tolerance: Insights for the Private Wealth Manager,” the “current standard process of risk profiling through questionnaires is found to be highly unreliable and typically explains less than 15% of the variation in risky assets between investors. The cause is primarily the design of the questionnaires, which focus on socioeconomic variables and hypothetical scenarios to elicit the investor’s behavior.”
He went on to explain that there are three problems questionnaires typically fail to address: Our genetic predisposition affects our willingness to take on financial risks, the people we interact with shape our views, and the circumstances we experience in our lifetimes—in particular, during the period psychologists call the formative years—influence our outlook.
Being aware of biases at least gives us a chance of addressing them, either on our own or with the help of a financial advisor. Michael Pompian provides guidance on behavioral biases in his article, “Risk Profiling Through a Behavioral Finance Lens,” for the aforementioned CFA Institute Research Foundation brief. (Pompian also is the author of the 2012 book “Behavioral Finance and Wealth Management,” which I recommend for both investors and advisors.)
In his article, Pompian places biases into two broad categories: cognitive and emotional. Cognitive biases have to do with how people think and result from memory errors or faulty reasoning.
He writes: “There are two types of cognitive biases: belief perseverance and information-processing biases. Belief perseverance biases concern people who have a hard time modifying their beliefs even when faced with information to the contrary. It is a very human reaction to feel mentally uncomfortable when new information contradicts information you hold to be true.”
Emotional biases are the result of reasoning that is influenced by feelings, especially during times of stress.
Pompian then analyzes four different investor types—conservative, moderate, growth and aggressive—and reviews the biases likely to be present with each type.
Conservative Investors
Their risk tolerance is low and they tend to make emotional errors. Being worriers, they tend to place great emphasis on financial security and preserving wealth, and to obsess over short-term performance. They also are slow to make investment decisions because they are uncomfortable with change and uncertainty. Their behavioral-bias orientation is emotional:
- Loss aversion: Feeling the pain of losses (especially realized losses) more than the pleasure of gains, they tend to hold onto losing investments too long.
- Status quo: They feel safe keeping things the same, even if they are not working optimally.
- Endowment: They assign greater value to an asset they already own than to a prospective purchase.
- Anchoring: They tend to cling to investments, anchoring on a specific price (such as the purchase price, or a historic high).
- Mental accounting: Treating different pockets of assets differently, they tend to use a “bucket” approach instead of evaluating the portfolio as a whole.
Moderate Investors
Their risk tolerance is moderate and they tend to make cognitive errors. They often do not have their own firm ideas about investing, instead following the lead of their friends and colleagues. They tend to be comfortable with the latest, most popular investments, often without regard to a long-term plan. In addition, they often overestimate their risk tolerance. Their behavioral-bias orientation tends to result in cognitive biases such as:
- Recency: The predisposition to recall and overweight recent events and/or observations and to extrapolate patterns where none may actually exist.
- Hindsight: Belief that investment outcomes were predictable.
- Framing: The tendency to respond to situations differently depending on the context in which a choice is presented (framed). For example, when questions are worded in a “gain frame” (e.g., an investor is asked to suppose an investment goes up), a risk-taking response is more likely. When questions are worded in a “loss frame” (e.g., an investor is asked to suppose an investment goes down), risk-averse behavior is the more likely response.
- Cognitive dissonance: When a person believes something is true only to find out that it is not, he or she tries to alleviate discomfort by ignoring the truth and/or rationalizing decisions (often ending up throwing good money after bad).
Moderate investors also tend to make the emotional error of regret-aversion bias, which is the fear of taking decisive action because they worry that, in hindsight, whatever course they select will prove unwise. Regret aversion can cause moderate investors to be too timid in their investment choices because of losses they have suffered in the past.
