The biases that were highlighted in Part I (generational and behavioral) are woven into the perception your client has of everything you say.
Further, your ability to translate what your client tells you into a workable investment strategy may hinge completely on your ability to recognize the effect these biases have on your client's goals.
This enables you to translate client goals into a financial language. And that bridges the divide between the institutional and individual portfolio models.
Although this is not the only way to utilize behavioral finance, it is a very important application. Let’s see how it can work.
In our 2008 case study scenario, a client comes in, meets with the advisor, and says he wants to add a significant position in GM stock to his portfolio.
You realize that the client’s real goals have less to do with adding a portfolio position and much more to do with passing on his values to his heirs.
How do we translate those goals into an investment strategy? By utilizing a graph Meir Statman created to illustrate the way investor behavior integrates into investment goals.
The graph shows the multiple levels and also the multiple categories of goals individuals have. Statman takes the everyday needs of individuals and lines up each with an investment goal.
We can apply Statman’s chart in a second graph that shows a step-by-step translation of those goals into an investment strategy.
Applying this to our case study, you could have asked questions that revealed the values this gentleman had that lay beneath his decision to buy GM stock.
You could have met with the family, compared GM and Amazon, and shown how each company represents the innovation and work ethic of America, each in its respective genre.
You might have been able to buy some time to see how GM would weather the financial crisis.
You might also have been able to successfully advise the family to take some partial profits in the Amazon position—not an unwise move in a possible changing market and economic climate. This would have freed up money to take advantage of other investment opportunities.
These graphical tools could have helped you in identifying the biases held by each family member. You would then have been in a position to educate the family about those biases, and open a discussion of the family’s real values.
You could then have been able to guide them in deciding more appropriate investments to reflect those values.
This may or may not have changed the actual construction of the portfolio. But it would have better aligned the investment strategy with the goals the family members were trying to accomplish.
And it would have solidified your relationship with each generation of that family.
Of course, by supposing this, we are illustrating our own proclivity to the bias of hindsight! Which is yet another way to utilize biases in better serving our clients.
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