We’ve all heard a lot about behavioral economics. Robert Shiller won this year’s Nobel Prize for it. Daniel Kahneman won for it in 2002. But how do you apply these principles to your actual practice?
For too long advisors have had access to the theoretical principles of how human nature influences financial decisions, but have not been provided with a coherent methodology for putting them to work.
At its simplest, this means going beyond native intuition to figure out why your most affluent clients act the way they do. The less purely subjective these systems are, the more accurate your efforts will be when it comes to getting the business out of your head and into theirs.
Why should we care?
Understanding your client’s behavior types is just as important as understanding their investment objectives.
One of the most common reasons advisors cite for losing accounts is that as St. Louis planner Michael Pompian puts it, “they didn’t really get into their clients’ heads.”
The logic here is simple. When clients are more deeply engaged in your relationship, they provide a richer stream of referrals. Knowing what your clients want is the first step toward reliably giving it to them, which in turn feeds their satisfaction and engagement in the relationship.
In other words, knowing the minds means winning the hearts. Meanwhile, simply understanding what makes each individual client tick allows you to add more value, or “alpha,” above and beyond simple investment returns. (Click HERE for more on the non-market-driven alpha RIAs can provide.)
And RIAs who can add that value have a natural advantage in the battle with “robo-advice” and more traditional competitors.
Understanding behavioral types
Michael Pompian’s Behavioral Alpha system standardizes that advantage by segmenting investors into behavioral investment types (BITs) to determine investment vulnerabilities and predispositions. (Click HERE for a more detailed video explanation of the system.)
Clients are assigned a BIT based on their level of risk tolerance and the primary bias – emotional or cognitive -- they exhibit, which makes this more than a one-dimensional survey-driven risk profile.
Furthermore, Pompian has observed that the most and least risk tolerant clients tend to suffer from emotional biases (driven by impulses or feelings), while the clients in between the extremes tend to exhibit cognitive biases driven by faulty reasoning.
It’s important to keep in mind that emotional biases are usually more difficult to overcome than their more logically oriented counterparts, which can be analyzed, argued against and ultimately corrected dispassionately and respectfully, and ideally the client will respond in kind.
An emotional response, however, can be very difficult to counter since emotionally based economic behaviors are generally more deeply seated and difficult to retrain.
In either event, knowing a client’s specific biases and risk tolerance allows the advisor to be much more objective and intentional when putting together an investment plan or proposal, while being able to communicate what to expect and why to expect it provides a huge edge in client satisfaction.
Institutionalize practices based on behavioral types
Pompian divides BITs into four categories: the passive preserver, friendly follower, independent individualist, and active accumulator.
There are specific strategies for communicating investment proposals as well as ongoing performance plans based on a client’s BIT score.
The passive preserver has a low risk tolerance and is apt to make decisions for emotional rather than calculated reasons. This investor needs advice that focuses on the big picture and is couched in plain language rather than statistics and jargon. An advisor would do well to keep discussion on a basic level.
The friendly follower is also passive, with a low to medium risk tolerance. However, the friendly follower will likely suffer from cognitive-based biases. In this case, the investor will generally respond well to education-based explanations. This category will often overestimate risk and chase after market trends.
An independent individualist is a much more active investor, with a medium to high risk tolerance and a tendency toward cognitive biases. With this investor, asset allocation should be more of a collaborative process. Education-based investment dialogue is again important, but here the investor will be unlikely to embrace a “plan” per se.
Lastly, the active accumulator will have a high risk tolerance combined with an emotional disposition. Here it is important that the advisor not capitulate to the client’s investment demands. Over time, the advisor should continually engage the client in discussions focused on long-term planning.
Basic components of a behavioral-driven portfolio approach
One of the keys to a behavioral-driven approach is determining the client’s BIT up front by integrating behavioral and traditional risk profiles into the enrollment process.
Once the profiling is completed, it’s time to lead into the presentation of BIT-specific investment strategies.
Investment proposals should be organized to present information in a manner that is compatible with how a particular BIT consumes information.
Next, using pre-configured, flexible or core/satellite models will provide you with the appropriate investment model and recommendation for the BIT.
Once you set up the model and allocation, the focus shifts to ongoing portfolio management and reporting. Since the four BITs process information differently, structuring your performance reporting to position “big picture” versus “detailed strategies,” for example, will resonate well with passive preserver types but not with the others.
Finally, depending on the BIT, tax and cash flow management features can be added to create a system of restraints and rewards applicable to the client’s behavioral tendencies.
A differentiated and differentiating client experience
All of these interactions create a richer client experience and ultimately better client outcomes.
The challenge is delivering this experience on a consistent level to a wide range of clients. This kind of implementation is a great example of how a customizable, fully integrated investment solution like Adhesion Wealth Advisor Solutions adds value.
You can leverage our behavioral questionnaires and proposal and report templates or build your own. You also have the option of using our pre-configured model portfolios, or choose to construct your own.
Together, these pieces facilitate your delivering a personalized experience that will truly differentiate you from the competition. When it comes to behavioral-driven portfolios, Adhesion can power your alpha.
A behavioral finance-driven approach is not only an enrollment strategy. It is a methodology for advisors to move from the reactive mode where the majority of time is spent putting out fires and anticipating clients to the proactive mitigation of the ways the client will sabotage strategy and generate his or her own problems.
Michael Stier, president of Adhesion Wealth Advisor Solutions, has been a leader in global financial services technology for over 30 years. Barrett Ayers, Adhesion's chief solutions officer, has been a leader in developing innovative advisor investment solutions for more than 20 years.
