Wednesday, July 1, 2009

Understanding the minds of retirees

A little knowledge about behavioral finance goes a long way in tough economic times

Investment News

By Michael M. Pompian May 21, 2009, 10:05 AM EST

Understanding how retiree investors are apt to behave can help advisers manage relationships during difficult market environments. …

To help advisers, I've identified four common behavioral investor types, or BITs, that reflect the patterns in which most people react to their environment.

Before we get to specific BITs, though, let's review the two types of biases that appear in all investors: cognitive and emotional.

A cognitive bias is a statistical, information-processing or memory error common to all human beings. Think of these errors as “blind spots” or distortions in the rational human mind.

Emotional biases, which are on the other end of the spectrum, are expressions — often involuntary — related to feelings, perceptions or beliefs that can exist in reality or in the imagination.

Often, because emotional biases originate from impulse or intuition rather than conscious calculations, they are difficult for an adviser to correct. Among the BITs I've identified, the least risk-tolerant are conservative investors I call passive preservers, who are mostly emotionally biased in their behavior.

There are many of these among advisers' retiree clients, so let's review their biases along the cognitive/emotional divide and consider how best to advise them.

Emotional biases:

• Loss aversion. Compared with others, conservative investors tend to feel the pain of losses more than the pleasure of gains. They often hold losing investments too long even when no prospect of a turnaround is in sight. …

• Status quo. Conservative investors often like to keep their investments … the same. They tell themselves that “things have always been this way,” and feel safe keeping things unchanged.

• Endowment. Conservative investors, especially clients who inherit wealth, tend to assign a greater value to investments that they own (such as a piece of real estate or an inherited stock position) than potential investments.

• Regret aversion. Conservative investors often avoid taking decisive actions, because they fear that in hindsight, whatever course they select will prove less than optimal. Regret aversion can cause them to be too timid in their investment choices because of losses they have suffered.

Cognitive biases:

• Anchoring. Conservative investors often are influenced by purchase points or arbitrary price levels. They tend to cling to these numbers when facing questions such as, “Should I buy or sell this investment?” Suppose that a stock is down 25% from a high it reached five months ago. A conservative client may resist selling until the price rebounds fully.

Mental accounting. Conservative clients often treat various sums of money differently, based on where those sums are mentally categorized. They may segregate assets into safe and risky “buckets.” But if all assets are viewed as safe money, suboptimal returns usually result.

As you can see, the behavioral biases of conservative clients are largely emotional. …

…[Focus] on how investment decisions affect issues that are emotionally important, such as family, legacies and lifestyle, and try to empathize with what clients are experiencing.

When working with conservative investors, look for these biases and advise clients accordingly. Understanding your client's behavior leads to better communication and a clearer understanding of the motivations behind investment decisions — and hopefully a better client -relationship.

Michael M. Pompian, a chartered financial analyst and certified financial planner, is director of the private-wealth practice at Hammond Associates, a St. Louis-based investment -consulting firm with $50 billion under advisement.

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