Understanding a Client's Risk

Tolerance Utilizing Behavioural 4

Finance Techniques

CONTENT AREAS

What is Behavioural Finance?

What is the Relevance of Behavioural Finance to the Wealth Advisor?

What are Risk Tolerance Questionnaires and Their Limitations?

What are Investor Biases?

What are Investor Personality Types?

How do Wealth Advisors Apply Bias Diagnoses When Structuring Asset Allocations?

LEARNING OBJECTIVES
By the end of this lesson, you should be able to:

1 | Describe the theory of behavioural finance.

2 | Explain the benefits of using the principles of behavioural finance when working with clients.

3 | Explain the drawbacks of traditional risk tolerance questionnaires.

4 | Identify cognitive and emotional client biases.

5 | Incorporate client bias diagnoses into strategic asset allocation discussions and decisions.

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KEY TERMS

Key terms appear in bold text in the chapter.

behavioural finance fundamental anomaly

behavioural finance macro heuristics

behavioural finance micro homo economicus

best practical allocation hot hand fallacy

bias January effect

calendar anomaly non-fungible

cognitive bias standard deviation

efficient frontier technical analysis

efficient market hypothesis technical anomaly

emotional bias

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INTRODUCTION
There are two camps in the world of finance: standard finance and behavioural finance. Standard finance embodies
the notion that investors are inherently rational economic beings; whereas behavioural finance holds that investors
are human beings, rather than idealized logical creatures, and therefore personal beliefs and biases influence the
investor’s risk tolerance. The conversation about risk is one of the most important parts of the wealth management
advisor relationship. In this lesson, we will take a closer look at behavioural finance and how it helps wealth advisors
gain a better understanding of the client’s risk tolerance.

WHAT IS BEHAVIOURAL FINANCE?

Behavioural finance is commonly defined as the application of psychology to understand human behaviour in
finance or investing. The term appears in many books, magazines, and other media, but many people still lack a
clear understanding of the concepts behind behavioural finance or what it really means. One cause of this confusion
is the variety of disciplines that resemble behavioural finance, such as behavioural science, investor psychology,
cognitive psychology, behavioural economics, experimental economics, and cognitive science. The discussion of
behavioural finance can be split into two subtopics:
• Behavioural finance micro, which examines the irrational behaviour of individual investors
• Behavioural finance macro, which examines irregularities in the overall market

MICRO VERSUS MACRO

Behavioural finance micro examines the behavioural bias (i.e., irrational behaviours) of individual investors.
It compares irrational investors to rational investors envisioned in classical economic theory, known as homo
economicus or “rational economic human being”. Behavioural finance macro, on the other hand, describes
anomalies or irregularities in the overall market that contradict the efficient market hypothesis.
Many students of the securities markets are taught that markets are efficient. However, researchers have uncovered
abnormal market behaviours, such as the January effect and other instances of human behaviour that influences
securities prices; and therefore, markets. For wealth advisors, the primary focus of behavioural finance is micro—the
study of individual investor behaviour. Specifically, wealth advisors seek to identify relevant psychological biases
that their clients might have and to investigate their influence on asset allocation decisions. Doing so can help the
advisor manage the effects of those biases on the investment process and enable the clients to meet their financial
goals.

EXAMPLE
A client who is subject to loss aversion bias will likely hold on to losing investments too long. An advisor who is
able to identify this bias in the client can help the client overcome this damaging behaviour and, therefore, make
better asset allocation decisions.

To gain an understanding of behaviour finance micro, the wealth advisor must consider the central question of
irrational versus rational behaviour—do individual investors behave rationally or do cognitive (i.e., conscious
intellectual activity such as thinking, reasoning, and remembering) and emotional errors influence the financial
decisions of investors? Much of economic and financial theory is based on the notion that individuals act rationally
and consider all available information in the financial decision- making process. However, many researchers have
documented evidence of irrational behaviour and repeated errors in financial judgment. The most fundamental
topic in behavioural finance research is the classic debate of homo economicus versus the behaviourally biased
individual.

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RATIONAL ECONOMIC INDIVIDUALS VERSUS BEHAVIOURALLY BIASED INDIVIDUALS

First established in neo-classical economics, homo economicus (or rational economic human being) is a model of
human economic behaviour. According to this theory, three basic principles rule all economic decisions made by
individuals:
• Perfect rationality
• Perfect self-interest
• Perfect information

Homo economicus is a model that academics and practitioners believe in with varying degrees of stringency. Some
believe in a strong form, which holds that irrational behaviour does not exist. Others have adopted a semi-strong
form, which sees an abnormally high occurrence of rational economic traits. The last group of economists supports
a weak form of homo economicus, in which the irrational traits exist but are not strong.
All of these versions share the core assumption that humans are “rational economic maximizers”, who are self-
interested and make rational economic decisions. Economists like to use this principle because it makes economic
analysis relatively simple and it allows economists to quantify their research findings, which makes their work easier
to teach and disseminate. The idea is that if humans are perfectly rational, display perfect self-interest, and have
perfect information, their behaviour can be quantified.
Most criticism of homo economicus challenges the bases for these three underlying assumptions.

CRITICISM OF PERFECT RATIONALITY

When humans are rational, they have the ability to make logical and self-interested judgments. However, many
would agree that rationality is not the sole driver of human behaviour. In fact, many psychologists believe that the
human intellect is actually subservient to human emotion. They contend that human behaviour is less the product
of logic than of subjective impulses such as fear, love, hate, pleasure, and pain, and that humans use their intellect
only to achieve or avoid emotional outcomes. Thus, from this perspective, perfect rationality is only a theoretical
construct, not a practical occurrence.

CRITICISM OF PERFECT SELF-INTEREST

Many studies have demonstrated that human beings are not perfectly self-interested. If they were, neither
philanthropy nor charity would exist. Most religions promote selflessness, sacrifice, and kindness and have done
so for centuries. Perfect self-interest would preclude people from performing unselfish acts of kindness such as
volunteering or helping the underprivileged. Perfect self-interest would also prohibit self-destructive behaviour such
as suicide, alcoholism, and substance abuse. Therefore, the argument that people are perfectly self-interested is
weak.

CRITICISM OF PERFECT INFORMATION

Some people may have perfect or near-perfect information on certain subjects. For example, a doctor should be
well versed in the inner workings of the human body. It is not possible, however, for every person to enjoy perfect
knowledge of every subject in existence. For example, assume that you need to buy a loaf of bread. If you had
perfect information, you would know the price of every loaf of bread for sale in every shop in town. But perfect
information does not exist in the real world. Many other good examples can be found in the world of investing, in
which there is nearly an infinite amount to know and learn, and even the most capable investors don’t master all
disciplines. It is hard to believe that anyone has perfect information, especially in the investing realm.
Therefore, people are neither perfectly rational nor perfectly irrational. They have diverse combinations of rational
and irrational characteristics, and can benefit from an advisor’s help with respect to their shortcomings. Another
core concept in behavioural finance that is important to discuss at this point is the issue of standard finance versus
behavioural finance.

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STANDARD FINANCE VERSUS BEHAVIOURAL FINANCE

Meir Statman is one of the great contributors to the field of behavioural finance. For Statman, the foundations of
standard finance were built by several important intellectual leaders of finance: the Miller and Modigliani arbitrage
pricing principles; the Markowitz portfolio principles; Sharpe’s capital asset pricing model; and the Black, Scholes,
and Merton option pricing theory. These intellectual leaders of finance provide mathematical explanations for
complex finance questions that, when posed in the real world, are complicated by imprecise and challenging
conditions. The standard finance approach relies on a set of assumptions that often oversimplify reality. For
example, embedded within standard finance is the concept already introduced of homo economicus, or the rational
economic human being, which is an interesting theory but impractical in reality.
Standard finance is characterized by rules about how investors should behave rather than by principles describing
how they actually behave. Behavioural finance, on the other hand, identifies with and learns from human behaviour
demonstrated by individual investors in financial markets. Behavioural finance, like standard finance, contains
underlying assumptions, but standard finance grounds its assumptions in idealized financial behaviour, whereas
behavioural finance grounds its assumptions in observed financial behaviour.

EFFICIENT MARKETS VERSUS IRRATIONAL MARKETS

During the 1970s, the standard finance theory of market efficiency became an accepted model of market behaviour
by many academics and professionals. The efficient market hypothesis was developed from the doctoral dissertation
of Eugene Fama, a professor at the University of Chicago. Fama believed and demonstrated that, in a securities
market populated by many well-informed investors, investments will be accurately priced and reflect all available
information.1 There are three forms of the efficient market hypothesis:
• Weak form: All past market prices and data are fully reflected in current securities prices—technical analysis is of
little or no value.
• Semi-strong form: All publicly available information is fully reflected in current securities prices— fundamental
analysis is of no value.
• Strong form: All information (including insider information) is fully reflected in current securities prices.

Many market efficiency studies point to evidence that supports the efficient market hypothesis. Researchers have
documented numerous, persistent anomalies, however, that contradict the efficient market hypothesis. There are
three main types of market anomalies that advisors should know about:
• Fundamental anomalies
• Technical anomalies
• Calendar anomalies

A fundamental anomaly is an irregularity in a security’s current price when compared to a fundamental

assessment of its intrinsic value. For example, there is a theory that investors consistently overestimate the
prospects of growth companies and underestimate the value of out-of-favour companies. In a totally efficient
market, this would not happen. Fama and his colleague Ken French performed a study of low price-to-book-value
ratios that covered the period between 1963 and 1990.2 The study considered all equities listed on the New York
Stock Exchange, the former American Stock Exchange, and NASDAQ in the United States. The stocks were divided
into 10 groups by book and market value and were re-ranked annually.

1
Fama, Eugene F. “Random Walks in Stock-Market Prices.” Selected Papers; No. 16; Chicago Graduate School of Business: University of
Chicago, 1965.
2
Fama, Eugene, and French, Ken. “The Cross-Section of Expected Stock Returns.” Journal of Finance (1992). Winner of the Smith-Breeden prize
for the best paper in the Journal of Finance in 1992.

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The highest book and market value stocks outperformed the lowest book and market value stocks 21.4% to 8%,
with each decile (representing 10% of the sample or population) performing more poorly than the previously
ranked, higher-ratio decile. They also ranked the deciles by beta (the measure of an investment’s volatility relative
to the market as a whole) and found that the value stocks posed lower risk and the growth stocks had the highest
risk. This result encouraged many investors to buy value stocks. The methodology contained in the analysis is widely
used today and is based on inefficient market conditions.
A technical anomaly is rooted in a form of market examination called technical analysis. Technical analysis
attempts to forecast securities prices by studying past prices. Sometimes, technical analysis reveals inconsistencies
with respect to the efficient market hypothesis. Patterns emerge that are called technical anomalies. In general, the
majority of research-focused technical analysis trading methods are based on the principles of the weak form of the
efficient market hypothesis. Many believe that prices adjust rapidly in response to new stock market information
and that technical analysis techniques are not likely to provide any advantage to investors. However, proponents
continue to argue the validity of certain technical strategies and use them frequently.
A calendar anomaly is an irregular securities pattern that emerges during certain times of the year, such as the
January effect mentioned earlier. The January effect shows that stocks in general, and small stocks in particular,
move abnormally higher during the month of January. Robert A. Haugen and Philippe Jorion, two researchers in
this area, found that the January effect is probably the best-known worldwide example of anomalous behaviour in
security markets.
The January effect is particularly illuminating because it hasn’t disappeared despite being well known for many
years; arbitrage theory (taking advantage of a state of imbalance between two or more markets) tells us that
anomalies should disappear as traders attempt to exploit them. From a practical standpoint, the January effect is
attributed to stocks rebounding following year-end tax-loss selling. Individual stocks depressed near year-end are
more likely to be sold for tax reasons.

WHAT IS THE RELEVANCE OF BEHAVIOURAL FINANCE TO THE

WEALTH ADVISOR?
In this section, we will discuss how the wealth advisor can leverage behavioural finance to improve the advisor–
client relationship and help clients make better investment decisions. Some advisors may view behavioural finance
as a “new” concept and be reluctant to accept its validity. In fact, irrational behaviour has been around for centuries,
and it should be acknowledged freely. Other advisors may not feel comfortable asking their clients psychological or
behavioural questions in an attempt to learn their biases, especially at the beginning of the advisory relationship.
However, in the coming years, behavioural finance will become a mainstream aspect of the wealth management
relationship, for both advisors and clients.
Certainly, if wealth advisors understand how investor psychology can affect individual investor decisions, and
consequently their investment outcomes, that insight can only benefit the advisory relationship. A key result of a
behavioural finance enhanced relationship will be a portfolio that the client can live with during up markets and
down markets. Clients who understand their own investing behaviour—learned through working with their wealth
advisors—will develop stronger relationships with their advisors. The following example illustrates how investor
psychology can help in the advisor–client relationship.

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EXAMPLE
During the late 1990s, many clients did not stick to asset allocation principles and concentrated their
investments in technology stocks. Knowledgeable advisors counselled their clients to rebalance their accounts by
selling large-cap growth stocks and reinvesting in value stocks. Those who offered this advice, and whose clients
followed it, saw successful outcomes and gained the confidence of their clients.

Different advisors have different ways of measuring the success of an advisory relationship. In addition to monetary
aspects, successful relationships share at least four fundamental characteristics:
• The advisor clearly understands the client’s financial goals.
• The advisor uses a structured, consistent approach to advising the client.
• The advisor delivers what the client expects.
• Both the client and the advisor benefit from the relationship.

So, how can behavioural finance lead to a successful advisory relationship?

UNDERSTANDING A CLIENT’S FINANCIAL GOALS

The foundation of a successful advisor–client relationship is the clear definition of the client’s financial goals. The
advisor also needs to know the client’s risk tolerance, return objectives, tax situation, and other technical aspects
of the client’s financial situation. It is helpful for the advisor to understand the psychology and emotions underlying
the decisions behind the client’s specified goals. Wealth advisors may sometimes find themselves in the role of
psychologists—assessing what the client’s motives are when making financial decisions. In other cases, advisors
have to “save” the client from their own poor decision- making. Naturally, the better the advisor knows the client,
the easier it is to psychologically assess the client’s needs.
After understanding their client’s financial objectives, wealth advisors can help them make better investment
decisions by considering the remaining three fundamental characteristics of the successful advisory relationship.

MAINTAINING A CONSISTENT APPROACH

Most successful advisors provide a consistent approach to delivering wealth management services. Successful
investing is a process, not a monthly or quarterly guess as to what investment will be in vogue, and incorporating
the principles of behavioural finance into the advisory relationship should become part of that disciplined process.
Clients need regular feedback from their advisors on their investment behaviour. A meeting (held quarterly or
semi-annually) could involve a review of not only investment results, but also investment decisions that were
recommended by the advisor and made by the client. With such a review, the advisor gains a knowledge base of
behavioural finance for his future reference.
Once a foundation of knowledge in behavioural techniques is gained, the advisor will be able to consistently assess
his clients’ behaviour, which will add more professionalism and structure to those relationships. Most clients
appreciate their advisors’ efforts in getting to know them better, and these relationships will, more than likely, be
more successful.

WHAT THE CLIENT EXPECTS

A client expects two main things from his advisor:
• An understanding of the client’s objectives based on a needs assessment
• Investment returns that are consistent with those objectives (and other aspects such as risk tolerance)

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There is perhaps no other aspect of the advisory relationship that could benefit more from behavioural finance than
delivering what the client expects. Advisors who can incorporate behavioural finance into meeting these two key
expectations will benefit enormously. For example, many clients overestimate their risk-return profile. Advisors who
can identify behavioural issues—such as bringing into focus a client’s actual risk tolerance—before they become a
problem will be able to deliver on client expectations consistently. In many instances, the advisor does not attempt
to understand the behaviour that drives the client’s investment decision-making, and therefore fails to help clients
reach their objectives.

ENSURING MUTUAL BENEFITS

Any measures taken that result in happier, more satisfied clients strengthen the advisor’s practice and enhance the
advisor’s work life. A client who is happy and satisfied will have financial security and confidence and have no reason
to seek the services of a competing advisor. When both the client and the advisor benefit, a strong relationship
usually results. Incorporating insights from behavioural finance into the advisory relationship enhances it and leads
to more fruitful results for both client and advisor.
Average or even slightly below average investment results are often not the primary reason that a client seeks a
new advisor (although extremely poor returns are cause for major concern). The number one reason that an advisor
loses a client is that the client does not feel as though his advisor understands, or attempts to understand, his
financial objectives—and the inevitable result is a poor relationship. The primary benefit that the understanding and
application of behavioural finance offer is the strengthening of the bond between client and advisor—not only at the
beginning of the relationship, but as it develops. By thoroughly understanding the client’s needs and by developing a
comprehensive grasp of the client’s motivations and fears, the advisor can help the client better understand why the
portfolio is designed the way it is, and why it is the “right” portfolio for that client—regardless of what happens day
to day in the markets.
Behavioural finance stresses the importance of understanding the biases and psychological attitudes of the
individual investor. One method standard finance has used to measure clients’ risk tolerance or aversion is through
the use of risk tolerance questionnaires. As we will discuss in the following section, the traditional questionnaire’s
place in the advisory relationship is subject to some limitations.

WHAT ARE RISK TOLERANCE QUESTIONNAIRES AND THEIR

LIMITATIONS?
The wealth advisor’s pursuit in understanding a client’s investment psychology has to begin with a pointed and
purposeful conversation about risk. Although questionnaires provide some useful information, they do not reveal
the full picture of the client’s risk tolerance. Many financial firms, in an attempt to standardize asset allocation
processes, require their advisors to administer risk tolerance questionnaires to clients prior to making investment
recommendations.
Some typical questions are illustrated in the risk tolerance questionnaire example below.

RISK TOLERANCE QUESTIONNAIRE (SAMPLE)

1. What is your primary investment objective?
a. Aggressive growth of capital.
b. Growth of capital.
c. Growth and income.
d. Income.
e. Preservation of capital.

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2. What do you consider to be your investment horizon?

a. Less than a year.
b. One to two years.
c. Two to five years.
d. Five to 10 years.
e. Longer than 10 years.

3. Which of the following best fits you when you consider the risks and returns involved in investing?
a. Portfolio returns are the most important factor; risk is not really a factor.
b. Returns and risk should be balanced.
c. Risk is the most important factor.

4. Assume that historical returns approximate 11% for large-cap stocks, 12.5% for small-cap stocks, 5% for
Government bonds, 3.5% for Treasury bills, and inflation of 2.5%. Based on this information, what would you
expect as a return on your investment portfolio?
a. 0%–5%.
b. 5%–10%.
c. 10%–15%.
d. Greater than 15%.

5. At what point would you consider selling a losing investment?

a. A loss of 5%–10%.
b. A loss of 10%–15%.
c. A loss of 15%–20%.
d. A loss of 20%–30%.
e. I don’t sell even at a substantial loss.

6. How important is it for your investments to perform as well as benchmarks?

a. Very important.
b. Important.
c. Not important.

7. Which of the following statements best describes return expectations from your portfolio?
a. My return should significantly exceed inflation plus taxes.
b. My return should be slightly more than inflation plus taxes.
c. My return should keep pace with inflation plus taxes.
d. I only wish to preserve my principal.

8. How comfortable are you with your current or future income potential?
a. I feel very comfortable with my future income potential.
b. I am somewhat comfortable with my future income potential.
c. I feel that my future income potential is unstable.
d. I have no income stream in the foreseeable future.

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9. How should your bond portfolio be managed?

a. Short term.
b. Intermediate term.
c. Long term.
d. I don’t invest in bonds.

10. How should your equity portfolio be managed?

a. I want to maximize returns and I am not concerned with capital gains or income.
b. I want a return and I would like some capital gains, too.
c. I want to minimize capital gains and focus on returns.
d. I don’t invest in stocks.

BEHAVIOURAL BIAS
From a behavioural finance perspective, risk tolerance questionnaires seem more suited to institutional investors
than psychologically-biased individuals. For example, an individual client may request a change to his asset
allocation in response to short-term market fluctuations, but moving repeatedly in and out of an allocation can
cause long-term negative consequences to a portfolio. On the other hand, behaviourally aware institutional
investors may see panic selling as a buying opportunity.
Behavioural biases need to be identified before the allocation is executed, so that such problems can be avoided.
Advisors may feel the need to remind clients not to sell during down periods, and to hold on to winners during up
periods. Many clients have an innate desire to hold on to losing investments and to sell winners too quickly.
In addition to ignoring behavioural issues, risk tolerance questionnaires can generate different results when
administered in slightly varying formats to the same individual investor. The differences are usually a result of
variations in how questions are worded. Also, most risk tolerance questionnaires are administered once—at the
beginning of the advisory relationship—and are never revisited. However, risk tolerances change throughout a
person’s life; therefore, advisors need to update their files to keep risk tolerance information current.
Another critical issue with respect to risk tolerance questionnaires is that many advisors interpret the results too
literally. For example, a client might state that 20% of total assets is the maximum loss she would be willing to
tolerate in a single year. Does that mean that an ideal portfolio would place such a client in a position to lose 20%?
No, the advisor should set portfolio parameters to avoid incurring the client’s maximum tolerable loss in any period.
Therefore, risk tolerance questionnaires only provide guidelines for asset allocation, and should be used in concert
with behavioural assessment tools.

FRAMING BIAS
Another reason why risk tolerance questionnaires may yield information of limited usefulness is because of framing
bias in the design of some questions. Ideally, the phrasing of questions should not affect the questionnaire’s results,
but it can happen.
For example, assume that over a 10-year period, Fund A has returned an annual average of 12%, with a standard
deviation of 15% (standard deviation quantifies the amount of expected variation in an investment’s performance
from year to year based on historical data). The expectation is that 67% of Fund A’s returns will fall within one
standard deviation of the mean, for an annual average return of 12%. Similarly, 95% of returns will fall within two
standard deviations, and 99.7% within three standard deviations of the mean.

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Therefore, if Fund A’s mean return was 12% and its standard deviation was 15%, two-thirds of all returns produced
by the fund would equal 12%, plus or minus 15% (i.e., 67% of the time, Fund A would be expected to return
somewhere between –3% and 27%). Therefore, 95% of Fund A’s returns are expected to fall between –18% and
42%, and 99.7% of returns are expected to fall somewhere between –33% and 57%.
Now, let’s assume that one of the two questions below appears on an investor’s risk tolerance questionnaire. Both
questions concern Fund A, and both try to measure the investor’s comfort level with Fund A, given its average
returns and volatility.
However, the two questions frame the same situation differently. How might a client subject to a few common
behavioural biases respond to each of the two questions? Would the client’s answers be identical in both cases?
Let’s consider the first question:

QUESTION 1
Based on the chart below, which investment fund seems like the best fit for you based on your risk tolerance and
your desire for long-term return?

Portfolio Name 95% Probability Gain or Loss Range Long-Term Return

B 3% to 5% 4%

C –7% to 17% 7%

A –18% to 42% 12%

a. Fund B.
b. Fund C.
c. Fund A.

Now, let’s consider the second question, without any reference to the first question:

QUESTION 2
Let us assume you are contemplating investing money in Fund A. Based on the fund’s past performance, the
managers of Fund A expect that two-thirds of the time Fund A will earn between 27% and –3%. They also believe
that there is a small chance that it might earn less than –3% in some years. Will you invest in Fund A?
a. Yes, I will invest in A, because I am comfortable with the risk level.
b. I might invest in A, but I want to know more about the risk level.
c. No, I won’t invest in A, because I don’t want such a wide range of returns.

When describing risk, many advisors use one standard deviation as the measure of risk. Many do not explain two
or three standard deviations. There is a chance that a client will select similar answers for both questions. However,
there is also a good chance that many investors would answer these two questions differently. Specifically,
respondents might reject Fund A in Question 1, yet when faced with Question 2, might decide to proceed with
Fund A.
In Question 1, the column heading “95% Probability Gain or Loss Range” refers to two standard deviations
above and below the mean. In Question 2, the reader contemplates a return of one standard deviation. Because
Question 2 refers to only one standard deviation, rather than two, readers are less likely to consider the one-third
of all cases in which Fund A could lose more than 5% of its value (entering into the 95%, rather than the 67%,
probability gain or loss range).

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The implications of framing bias in this example are important: inconsistent responses to the two questions
discussed above could make the questionnaire ineffective and an inaccurate measure of investor risk tolerance.
Therefore, advisors need to be aware of how framing can affect the outcome of various investment choices.

WHAT ARE INVESTOR BIASES?

To effectively establish the nature and priorities of an investor’s hierarchy of needs, the wealth advisor must
consider investor biases.
A bias can be described as a preference or an inclination (especially one that inhibits impartial judgment) or an
unfair act or policy stemming from prejudice.3 In the investment realm, behavioural biases are defined as systematic
errors in financial judgment or imperfections in the perception of economic reality. Over the past 25 years or so,
researchers have identified a long list of investor biases, categorizing them according to a meaningful framework.
Some refer to biases as heuristics (i.e., simple, efficient rules of thumb); others call them beliefs, judgments, or
preferences; still others classify biases along cognitive or emotional lines. To work with clients, advisors are not
required to classify or categorize client biases. However, the advisor should understand the concepts and be able to
apply them to client situations.
At this point, it’s not important to make an elaborate distinction between types of biases; we can simply note
whether a particular bias is cognitive or emotional. Later in this lesson, we will see why it is useful to distinguish
biases in this way.

DIFFERENCES BETWEEN COGNITIVE AND EMOTIONAL BIASES

Behavioural biases fall into two broad categories—cognitive and emotional—with both options yielding irrational
judgments.
A cognitive bias can be technically defined as basic statistical, information processing, or memory errors that
are common to all human beings—like blind spots or distortions in the human mind. One of the most common
cognitive biases is anchoring bias, where a client becomes anchored to a stock’s price or a market level before
making an investment decision. Cognitive biases were first identified by Amos Tversky and Daniel Kahneman as
a foundation of behavioural economics. Tversky and Kahneman argue that cognitive biases are used in problem-
solving through heuristics, which include the availability heuristic and the representativeness heuristic.4
Cognitive biases are not a result of emotional or intellectual predisposition toward a certain judgment, but rather
from subconscious mental procedures for processing information.
Investors are subjected to large volumes of information and data. To make sense of it all, they opt for simplified
information processing when making investment decisions. A good example of this is evaluating a class of mutual
funds, such as U.S. small-capitalization, for example. Even using a research service such as Morningstar, which
helps clients screen funds, the information flow is so immense that they inevitably rely on shortcuts such as “best
12-month return” to make a fund choice. Because cognitive biases stem from faulty reasoning, better information
and advice can often correct them. Cognitive biases include heuristics, such as anchoring and adjustment,
availability, and representativeness biases. Other cognitive biases include ambiguity aversion, self-attribution, and
conservatism.
On the opposite side of the spectrum from illogical or distorted reasoning are the emotional biases. An emotion is
a mental state that arises spontaneously, rather than through conscious effort. Emotions are physical expressions,

3
The American Heritage Dictionary of the English Language, Fourth Edition. Copyright A9 2004, 2000 by Houghton-Mifflin Company.
4
Kahneman, D., and Tversky, A. “Prospect theory: An analysis of decisions under risk.” Econometrica, 1979.

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often involuntary, related to feelings, perceptions, or beliefs about elements, objects, or relations between them—in
reality or in the imagination.
Emotions can be undesired to the individual that feels those emotions, who may wish to control them but often
cannot. Investors can be presented with investment choices, and may make sub-optimal decisions by having
emotions affect these decisions. Because emotional biases originate from impulse or intuition rather than from
conscious calculations, they are often difficult to correct. Emotional biases include endowment, loss aversion, and
self-control.

OVERVIEW OF BEHAVIOURAL BIASES

An overview of 20 common biases is presented below. The first 14 items are cognitive biases; the remaining six
items are emotional biases.

COGNITIVE BIASES
1. OVERCONFIDENCE
Overconfidence is defined generally as unwarranted faith in one’s intuitive reasoning, judgments, and cognitive
abilities. People tend to overestimate both their predictive abilities as well as the precision of the information
they have been given. Sometimes, people realize that events they thought were certain to happen did not occur,
but they don’t learn from these mistakes. In the investing realm, people think they are smarter and have better
information than they actually do. For example, an investor may get a tip from a wealth advisor or read something
on the Internet about an investment opportunity, and then take action (i.e., make the decision to invest) based on a
perceived knowledge advantage.

2. REPRESENTATIVENESS
Generally, people like to stay organized, so they develop, over time, an internal system for classifying objects and
thoughts. When confronted with new circumstances that may be inconsistent with existing classifications, they
often rely on a “best fit” process to determine which category should house and form the basis for understanding
the new circumstance. This perceptual framework provides a practical tool for processing new information by
simultaneously incorporating insights gained from past experiences. Some new stimuli seem representative
of elements that have already been classified; although, in reality, there are differences. In such instances, the
classification reflex is wrong, and it produces an incorrect understanding of the new element that often persists and
biases future interactions with that element.
In the investment realm, a client may be presented with an investment opportunity that contains some elements
representative of a good investment. A desire to mentally classify the investment opportunity may cause the
client to classify what is really a poor investment opportunity as a good investment opportunity, based on the few
elements that are representative of a good investment opportunity. Initial public offerings are a good example of
this concept.

3. ANCHORING AND ADJUSTMENT

People are generally better at estimating relative comparisons rather than absolute figures. For example, assume
you are asked to estimate a value in an unfamiliar area (e.g., the distance to the moon) and are given an initial
default number (i.e., an anchor). You will likely adjust up or down from that initial point to reflect subsequent
information and analysis. Once the anchor is fine-tuned and re-assessed, it can mature into a final estimate.
To illustrate how this works in the investment world, assume that a client is asked whether the Dow Jones Industrial
Average will be higher or lower than 15,000 next year. Obviously, the answer will be either above 15,000 or
below 15,000. If the client were then asked to guess an absolute value of the same index for the next year, the
estimate would probably fall somewhere near 15,000. This is because the estimate is likely to be subject to an
anchoring effect from the previous response.

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4. COGNITIVE DISSONANCE
When people are presented with information that conflicts with pre-existing beliefs, they usually experience mental
discomfort, commonly referred to as cognitive dissonance. Cognitions, in psychology, represent attitudes, emotions,
beliefs, or values. Cognitive dissonance is a state of mental imbalance that occurs when contradictory cognitions
bump into one another. The term encompasses the response that arises as people struggle to relieve their mental
discomfort by trying to get conflicting cognitions to align. For example, an investor might invest in stock ABC,
initially believing that it is the best stock available.
However, when a new cognition that favours a substitute stock is presented, an imbalance occurs. Cognitive
dissonance takes over in an attempt to relieve the discomfort with the notion that perhaps the investor did not
purchase the best stock. People will go to great lengths to convince themselves they made the right decision, to
avoid mental discomfort associated with their initial investment.

5. AVAILABILITY
The availability bias is a heuristic that allows people to estimate the probability of an outcome based on how
prevalent or familiar that outcome appears in their lives. People exhibiting availability bias perceive easily recalled
possibilities as being more likely than outcomes that are harder to imagine or difficult to comprehend. One classic
example cites the tendency of most people to guess that shark attacks cause fatalities more frequently than
injuries sustained from falling airplane parts. However, the latter has been shown to be thirty times more likely to
occur. Shark attacks are, probably, assumed to be more prevalent because sharks invoke greater fear, or because
shark attacks receive a disproportionate degree of media attention. Mutual fund advertising is a good example of
availability bias. Investors who see a certain company’s advertisements frequently may believe that that company is
a good mutual fund company, when it’s possible that a company that does no advertising is better.

6. SELF-ATTRIBUTION
Self-attribution bias (also known as self-serving bias) is the tendency of individuals to ascribe their successes to
personal traits, such as talent or foresight, and to blame failure on outside influences, such as bad luck. Students
who do well on an exam, for example, might credit their own intelligence or work ethic, while students who fail
might cite unfair grading. Investors often incorrectly ascribe investment success to themselves, while investment
failure is usually someone else’s fault.

7. ILLUSION OF CONTROL
Illusion of control bias is the tendency of individuals to believe that they can control random outcomes when, in
reality, they cannot. This bias is often observed in casinos. Some casino patrons are sure that they can influence
a roll of the dice by blowing on them. In the casino game of craps, for example, research has shown that people
actually cast the dice more vigorously when they are trying to attain a higher number. In the context of investments,
some people think that they can control the outcome of their investments by their actions, which is pure fantasy, of
course.

8. CONSERVATISM
Conservatism bias is a mental state in which people cling to a prior view or forecast and do not acknowledge
or obtain new information that might change an existing view. For example, an investor who receives bad news
regarding a company’s earnings, which contradicts the earnings estimate issued the previous month, may under-
react to the new information. The investor instead maintains a belief in the more optimistic earlier estimate, rather
than acting on the updated information.

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9. AMBIGUITY AVERSION
People avoid making an investment or taking risks when probability distributions seem uncertain to them, because
they hesitate in situations of ambiguity. This tendency is referred to as ambiguity aversion. It appears in a wide
variety of contexts, especially with investing. Older clients may be more prone to ambiguity aversion.

10. MENTAL ACCOUNTING

First identified by University of Chicago professor Richard Thaler in 1980, mental accounting describes
people’s tendency to categorize and evaluate economic outcomes by grouping assets into non-fungible (non-
interchangeable) mental accounts.5 Mental accounting causes investors to treat various sums of money differently
based on where these sums are mentally categorized. The way that money is obtained (e.g., work, inheritance,
gambling, bonus) or the nature of the money’s intended use (e.g., leisure, necessities) can affect how that money is
treated.
For example, Thaler performed an experiment in which he offered one group of people $30 and a choice to either
keep the $30 or gamble it on a coin toss. A correct toss would add $9; an incorrect toss would subtract $9 from the
initial $30 gift. The majority of subjects (70%) chose to gamble, because they considered the $30 to be “found”
money. A second group of subjects was offered a slightly different choice. They were asked: would you rather
gamble on a coin toss, in which you will receive $39 for a win and $21 for a loss, or would you rather simply pocket
$30 and forgo the coin toss? The key difference is that the second group was not immediately given $30.
The second group reacted differently. Only 34% of the second group chose to gamble, even though the economic
prospects they faced were identical to those offered to the first group. In the experiment, the first group mentally
put the amount in a “found money” account and was therefore willing to risk it. The second group had not yet
“found” the money and was therefore less willing to risk it.

11. CONFIRMATION
Confirmation bias is a type of selective perception in which people emphasize ideas that confirm their beliefs, and
discount ideas that contradict their beliefs. For example, a person may believe that people wear more red shirts
during the summer than during any other time of the year; however, this position may be due to confirmation bias,
which causes that person simply to notice more red shirts during the summer because he wears red during the
summer, while overlooking shirt colours during other months. This tendency, over time, unjustifiably strengthens
the belief regarding the summertime concentration of red shirts. Investors may confirm things about a security they
want to confirm, such as good earnings, but may overlook negative factors affecting the outcome of an investment.

12. HINDSIGHT
After the outcome of an event is known, some people believe that the outcome was predictable – even if it was
not. This happens because actual outcomes are clear in a person’s mind but the myriad outcomes that could have
occurred but did not are rather fuzzy. Therefore, people tend to overestimate the accuracy of their own predictions.
Hindsight bias has been demonstrated repeatedly by investors: a stock goes up and an investor feels he “knew it all
along,” but in fact the outcome was unpredictable.

13. RECENCY
Recency bias causes people to recall and emphasize recent events more prominently than those that occurred in the
near or distant past. For example, recency bias can cause investors to ignore fundamental value and focus only on
recent upward price performance. When a return cycle peaks and recent performance figures are most attractive,
it is human nature to chase the promise of a profit. Asset classes become overvalued, and by focusing only on price
performance and not on valuation, investors risk principal loss when these investments revert to their mean or long-
term averages.

5
Thaler, R. H. “Towards a Positive Theory of Consumer Choice.” Journal of Economic Behavior and Organization, 1, 1980, 39–60.

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14. FRAMING
Framing bias is the tendency to respond to various situations differently, based on the context in which a choice
is presented (or framed). Everyday evidence of framing bias can be found at the grocery store. Many grocers will
price items in multiples – for example, “2 for $2” or “3 for $10”. The pricing doesn’t necessarily imply that any kind
of bulk discount is being offered. An item priced at “3 for $10” could also be available at a unit price of $3.33. The
optimistic or pessimistic manner in which an investment or asset allocation recommendation is framed can affect
people’s willingness to invest. Optimistically worded questions are more likely to be acted upon than negatively
worded ones, and optimistically worded answer choices are more likely to be selected than pessimistically phrased
alternatives. Framing contexts are often arbitrary and uncorrelated and, therefore, should not impact investors’
judgments. But often, they do.

EMOTIONAL BIASES
15. ENDOWMENT
People who are subject to endowment bias place more value on an asset they hold property rights to than on an
asset they do not hold property rights to. This behaviour is inconsistent with standard economic theory, which says
that a person’s willingness to pay for a good or object should be equal to the person’s willingness to sell the good or
object. Psychologists have found that the minimum selling prices that people state tend to exceed the maximum
purchase prices they are willing to pay for the same good. Investors continue to hold securities they own rather than
disposing of them in favour of better investing opportunities.

16. SELF-CONTROL
Self-control bias (really, a lack of self-control) is the tendency to consume today at the expense of saving for
tomorrow. Money is an area in which people often lack self-control. Behaviour displayed while paying taxes
provides a common example. Imagine that you know for certain that you must pay exactly $7,200 in income taxes
one year from now and are presented with two options: contribute $600 per month over the course of the next
year into a savings account earmarked for tax season, or increase income tax withholding by $600 each month,
thus avoiding the responsibility of writing out one large cheque at the end of the year. Rational economic thinking
suggests that the savings account approach would accrue interest and would actually be more than $7,200 at the
end of the year. However, many taxpayers choose the withholding option, because they realize that the savings
account plan could be complicated in practice due to a lack of self-control.

17. OPTIMISM
Empirical studies have demonstrated that with respect to almost any personal trait perceived as positive—
good looks, sense of humour, attractive physique, expected longevity—most people tend to rate themselves as
surpassing the population mean (i.e., the average of all items in a population). This tendency is known as optimism
bias. Investors, too, tend to be overly optimistic about the markets, the economy, and the potential for positive
performance of their investments. Many overly optimistic investors believe that bad investment outcomes will not
happen to them but only to other people. However, everyone makes bad investment decisions, even the legendary
Warren Buffett (one of the richest people in the world).

18. LOSS AVERSION

Loss aversion bias was developed as a concept by Daniel Kahneman and Amos Tversky in 1979 in response to the
observation that people generally feel a stronger impulse to avoid losses than to acquire gains.6 The possibility of a
loss is, on average, twice as powerful a motivator as the possibility of making a gain of equal magnitude. That is, a
loss-averse person might demand, at minimum, a two-dollar gain for every one dollar placed at risk. In this scenario,
risks that don’t “pay double” are unacceptable. Loss aversion can prevent people from unloading unprofitable
investments, even when they see little to no prospect of a turnaround. Some industry veterans have coined the

6
Kahneman and Tversky, 1979.

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diagnosis “get-even-itis” to describe this condition, whereby a person waits too long for an investment to rebound
following a loss.

19. REGRET AVERSION

People who are subject to regret aversion bias avoid making decisions because they fear, in hindsight, that whatever
they decide to do will result in a bad decision. An example of regret aversion is observed when investors hold on to
losing positions too long in order to avoid admitting errors and realizing losses. When investors experience negative
investment outcomes, they feel instinctually driven to sell—not to press on and snap up potentially undervalued
stocks. However, periods of depressed prices often present the greatest buying opportunities. People suffering from
regret aversion bias, therefore, hesitate most at moments that actually may merit aggressive behaviour.

20. STATUS QUO

Status quo bias is an emotional bias that predisposes people, when faced with a wide variety of options, to choose
to keep things the same (i.e., to maintain the status quo). The scientific principle of inertia, which states that a
body at rest shall remain at rest unless acted upon by an outside force, is a similar concept. Status quo bias can
cause investors to hold securities with which they feel familiar or emotionally fond. This behaviour can compromise
financial goals, however, because a subjective comfort level with a security may not justify holding onto it because
of poor performance.

IDENTIFYING BEHAVIOURAL BIASES IN CLIENTS

Some advisors have a natural tendency to identify irrational behaviours in their clients; others need some
assistance. For example, some clients are averse to loss, which leads them to make irrational decisions. Wealth
advisors should be able to detect this bias in their clients. However, some advisors need assistance with this skill.
The brief diagnostic test example below helps detect loss aversion by clients. The test can help to provide an
understanding of how a bias is diagnosed.

TEST FOR LOSS AVERSION (SAMPLE)

The test begins by posing the following two questions to the client:
Question 1: Choose between the following two outcomes:
a. An assured gain of $475
b. A 25% chance of gaining $2,000, and a 75% chance of gaining nothing

Question 2: Choose between the following two outcomes:

a. An assured loss of $750
b. A 75% chance of losing $1,000, and a 25% chance of losing nothing
How is the loss-averse client likely to respond?

SCORING GUIDELINE
Question 1: The rational response is option b, but loss-averse investors are likely to opt for the assurance of a gain in
option a.
Question 2: The rational response is option a, but loss-averse investors are more likely to select option b.
Some advisors may be well aware of the various biases of their clients, but are still left wondering, “What do I do
with this knowledge?” This question will be addressed by the end of this lesson. We will discuss how advisors create
a behaviourally adjusted portfolio, one that moderates or adapts to a client’s biases.

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Before we get to that discussion, however, let’s consider an equally intriguing question regarding gender differences
that may affect an investor’s decision-making behaviour.

GENDER AND BEHAVIOURAL FINANCE

Gender and behavioural finance is a potent subject. Men and women behave quite differently when it comes to
investing, and it is important to understand and remember these differences. This section reviews some pertinent
studies on the link between gender and behavioural finance biases, and then offers some conclusions about how
certain biases apply to women and men.
Perhaps the most prominent and comprehensive gender-focused study was completed by Barber and Odean
(2001), entitled “Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment”.7 The study concludes
that men are more subject than women to the overconfidence bias as reflected in trading behaviour. By examining
investment transactions of 35,000 households from 1991 to 1997, these researchers found that, on average, men
traded 45% more than women, and single men traded 67% more than single women. When it came to returns,
Barber and Odean found similar results. On average, women underperformed a buy-and-hold approach by
about 1%, men underperformed by 1.4%, and single men by 2%. It appears that women in a household reduce the
risk-taking of the family and have more patience than men in investing activities.
In the fall 2004 issue of Institutional Investor’s Journal of Wealth Management, John Longo and Michael Pompian
(author of the book Behavioral Finance and Wealth Management) published an article entitled “A New Paradigm for
Practical Application of Behavioral Finance: Creating Investment Programs Based on Personality Type and Gender to
Produce Better Investment Outcomes”.8 During the summer of 2002, they administered to 51 women and 49 men a
Myers-Briggs Type Indicator personality test and a behavioural finance bias questionnaire. They asked the question,
“Did respondents of opposing personality extremes— and male and female respondents—reveal different investor
biases?” For example, did extraverts respond to a particular question differently from introverts, and did women
respond differently from men?
Their findings showed that many personality types and both genders are differentially disposed to numerous
behavioural finance biases. With regard to gender differences, they arrived at the following conclusions:
• Women are more susceptible than men to the hot hand fallacy, which refers to people believing that random
sequences (with no automatic correlation) display an actual positive correlation. For example, many basketball
coaches and players believe that a player who has made several shots in a row has a “hot hand,” and is therefore
more likely than usual to make the next shot. These people detect a pattern that is not proven to exist.
• Men are more overconfident and optimistic than women.
• Women are more likely to buy and hold.
• Men are one-third more risk tolerant than women.

In November 2005, Alexandra Niessen and Stephan Ruenzi, from the University of Cologne, completed a study
entitled “Gender and Mutual Funds”.9 They examined all single managed U.S. equity mutual funds from 1994 to
2003. In the study, 10% of fund managers were women. The researchers found that female managers take less risk,
follow less extreme investment styles (i.e., execute more consistent styles), are less overconfident, and trade less.
Women who are less risk tolerant and trade less tend to balance out men who tend to be aggressive in these areas.
Wealth advisors should listen to both the male and the female partner, and attempt to arrive at a risk assessment
that reflects a balance between them.

7
Barber, B. and Odean, T. “Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment.” Quarterly Journal of Economics,
Vol. 116, No. 1, 2001, 261–292.
8
Pompian, M. and Longo, J. “A New Paradigm for Practical Application of Behavioral Finance: Creating Investment Programs Based on
Personality Type and Gender to Produce Better Investment Outcomes.” Institutional Investor’s Journal of Wealth Management, Fall 2004.
9
Niessen, A and Ruenzi, S. “Sex Matters: Gender and Mutual Funds.” Department of Finance, University of Cologne, Germany, November 2005.

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In April 2005, Merrill Lynch Investment Managers completed a study entitled “When It Comes to Investing, Gender
Is a Strong Influence on Behavior”.10 They surveyed 500 male and 500 female clients for their attitudes, beliefs, and
knowledge levels on investing. They found that:
• Women are less likely to hold losing investments too long (35% versus 47%).
• Women are less likely to sell a winning investment too quickly (28% versus 43%).
• Men are more likely to allocate too much money to one investment (32% versus 23%).
• Men are more likely to buy a hot investment without doing research (24% versus 13%).
• Men are more likely to trade too much (12% versus 5%).

Table 4.1 provides a summary of major male and female biases. Generally, men are more susceptible to cognitive
biases and women are more susceptible to emotional biases.

Table 4.1 | Typical Biases to Which Men and Women are Susceptible

Men are susceptible to: Women are susceptible to:

Overconfidence bias (Cognitive) Endowment bias
Loss aversion bias (E) (Emotional) Status quo bias (E)
Availability bias (C) Representativeness bias (C)
Cognitive dissonance bias (C) Regret aversion bias (E)

WHAT ARE INVESTOR PERSONALITY TYPES?

Some large financial firms have conducted studies in which people were classified under various different categories,
including reluctant investors, competitive investors, analytical investors, and so on. Individual advisors, academics,
and other researchers have made some interesting correlations between psychological traits and financial
behaviour. For example, some personality types have little time or patience for managing money, some start
investing too late, and some show more discipline than others. Below we discuss eight common investor personality
categories within three different dimensions.

EIGHT INVESTOR PERSONALITY TYPES

The three investor personality dimensions that form the eight personality types are as follows:
• Idealism (I) versus Pragmatism (P)
• Framing (F) versus Integrating (N)
• Reflecting (T) versus Realism (R)

Combining the elements of the above three different dimensions, eight possible investor personality types emerge,
as follows: IFT, IFR, INT, INR, PFT, PFR, PNT, and PNR. Each of the three dimensions, and the types of investors that
fall within these dimensions, are described in detail below.

10
Frank, M. and Bishop, S. “When It Comes to Investing, Gender a Strong Influence on Behavior.” Hindsight to Insight. Merrill Lynch Investment
Managers, April 2005.

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IDEALISM VERSUS PRAGMATISM (I VERSUS P)

People who fall into the “idealist” end of the I versus P spectrum overestimate their investing abilities, display
excessive optimism about the capital markets, and do not seek out information that contradicts their views. For
example, many investors continued buying technology stocks even as they fell during the meltdown in 2000,
eternally optimistic that these stocks would make a comeback. They discern patterns where none exist, and believe
that their above-average market acumen gives them an exaggerated degree of control over the outcomes of their
investments.
Often disinclined to thorough research, these people can fall prey to speculative market fads. Idealists can be
susceptible to the following biases: overconfidence, optimism, availability, self-attribution, illusion of control,
confirmation, recency, and representativeness. Pragmatists, on the other hand, display a realistic grasp of their own
skills and limitations as investors. They are not too overconfident about the capital markets and demonstrate a
healthy dose of scepticism regarding their investing abilities. They understand that investing is an undertaking based
on probabilities, and do research to confirm their beliefs. Pragmatists are investors who are typically not susceptible
to the aforementioned biases.

FRAMING VERSUS INTEGRATING (F VERSUS N)

Framers tend to evaluate each of their investments individually and do not consider how each investment fits into
an overall portfolio plan. They are too rigid in their mental approach to analysing problems. The framer’s portfolio
is composed of unique “pots” of money, rather than a composite of well-managed investments. For example, these
investors typically have different allocations for “retirement money”, “vacation money”, and “university savings”.
This is not necessarily a bad thing, but advisors need to watch for overlap among allocation to guard their clients
against over-concentrating in one asset class.
Framers also subconsciously “anchor” their estimates of market or security price levels, clinging to arbitrary
purchase “points”, which leads to bias in future calculations. Integrators, on the other hand, are characterized by
an ability to contemplate broader contexts and externalities. They correctly view their portfolios as systems whose
components can interact and balance one another out. Integrators understand the correlations between various
financial instruments and structure their portfolios accordingly. They are also flexible in their approach to market
and security price levels. Framers may be susceptible to the following biases: anchoring, conservatism, mental
accounting, framing, and ambiguity aversion. Integrators are investors who are typically not susceptible to the
aforementioned biases.

REFLECTING VERSUS REALISM (T VERSUS R)

Reflectors have difficulty living with the consequences of their decisions and have difficulty taking action to rectify
their behaviours. They justify and rationalize incorrect actions and hesitate to own up to decisions that have not
worked out beneficially. They also suffer from decision paralysis because they dread the sensation of regret, should
they miscalculate. An example of this type of behaviour is holding inherited securities—out of a sense of loyalty to
a deceased relative—that may not be a good fit in a diversified portfolio in the current investment environment.
Realists, on the other hand, have less trouble coming to terms with the consequences of their choices. They don’t
tend to scramble for excuses in order to justify incorrect actions, and they assume responsibility for their mistakes.
Realists also have an easier time than reflectors with decision-making under pressure because they don’t experience
regret as acutely and, therefore, don’t dread it ahead of time. Reflectors may be susceptible to the following biases:
cognitive dissonance, loss aversion, endowment, self-control, regret aversion, status quo, and hindsight. Realists are
investors who are typically not susceptible to the aforementioned biases.

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HOW DO WEALTH ADVISORS APPLY BIAS DIAGNOSES WHEN

STRUCTURING ASSET ALLOCATIONS?
Many wealth advisors, when designing an asset allocation program for a client, typically first administer a risk
tolerance questionnaire, then discuss the client’s financial goals and constraints, and then recommend the output of
a computer-generated asset allocation. Less-than-optimal outcomes are often a result of this process because the
client’s psychological biases may not be accounted for.
Instead, investors may be better served by moving themselves up or down the efficient frontier (a set of optimal
portfolios), adjusting risk and return levels depending on their behavioural tendencies. Michael Pompian calls this
a client’s best practical allocation, which may slightly underperform over the long term and have lower risk, but
is an allocation that the client can comfortably adhere to over the long run. Many clients, in response to a market
downturn, want to sell in a panic. Conversely, a client’s best practical allocation might contradict their natural
psychological tendencies, and these clients may be well served to accept risks that are higher than their individual
comfort levels to maximize expected returns. The ability to create best practical allocations is what wealth advisors
should gain from this section.
The last section of this lesson has been adapted from an article by Longo and Pompian (originally published in the
Journal of Financial Planning in March 2005). It sets forth two principles for constructing a best practical allocation,
in light of client behavioural biases:
• Moderate biases in less-wealthy clients and adapt to biases in wealthier ones
• Moderate cognitive biases and adapt to emotional ones

These principles are not intended as prescriptive absolutes, but rather should be used along with other data on risk
tolerance, financial goals, asset class preferences, and other factors. The principles are also general enough to fit
almost any client situation.
When considering behavioural biases in asset allocation, wealth advisors must first determine whether to moderate
or adapt to “irrational” client preferences. This decision basically involves weighing the rewards of sustaining a
calculated, profit-maximizing allocation against the outcome of potentially affronting the client—whose biases
might position the client to favour a different portfolio structure entirely. Guidelines for resolving the puzzle of when
to moderate and when to adapt are presented below.

MODERATE BIASES IN LESS-WEALTHY CLIENTS AND ADAPT TO BIASES IN

WEALTHIER ONES
The prospect of your clients outliving their assets constitutes a far graver investment failure than an inability to
accumulate the greatest possible wealth. If an allocation performs poorly because it conforms, or adapts, too
willingly to a client’s biases, then a less-wealthy client’s standard of living could be seriously jeopardized. The most
financially secure clients, however, would likely continue to reside in the 99.9th socioeconomic percentile. In other
words, if a biased allocation could put a client’s way of life at risk, moderating the bias is the best response. If only
a highly unlikely event, such as a market crash, could threaten the client’s day-to-day security, overcoming the
potentially sub-optimal impact of behavioural bias on portfolio returns becomes a lesser consideration. Adapting is,
then, the appropriate course of action.

MODERATE COGNITIVE BIASES AND ADAPT TO EMOTIONAL ONES

As discussed earlier, behavioural biases fall into two broad categories—cognitive and emotional— with both
yielding irrational judgments. Because cognitive biases stem from faulty reasoning, better information and advice
can often correct them. On the other hand, because emotional biases originate from impulse or intuition, rather
than conscious calculation, they are difficult to rectify. Cognitive biases include heuristics, such as anchoring and

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adjustment, availability, and representativeness. Other cognitive biases include ambiguity aversion, self-attribution,
and conservatism. Emotional biases include endowment, loss aversion, and self-control.
In some cases, heeding these two principles simultaneously yields a blended recommendation. For example, a
less-wealthy client with strong emotional biases should be both adapted to and moderated. Figure 4.1 illustrates
this situation. Additionally, these principles tell us that two clients exhibiting the same biases should sometimes be
advised differently.
Figure 4.1 | A Visual Depiction of Best Practical Allocation

High Level of Wealth

(Adapt)

Moderate & Adapt Adapt

Cognitive Biases Emotional Biases
(Moderate) (Adapt)
Moderate Moderate & Adapt

Low Level of Wealth

(Moderate)

Source: Pompian, M. and Longo, J. “Incorporating Behavioral Finance Into Your Practice.” Journal of Financial Planning, March 2005, 58–63.

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 CHAPTER 4 | UNDERSTANDING A CLIENT'S RISK TOLERANCE UTILIZING BEHAVIOURAL FINANCE TECHNIQUES 4 • 23

SUMMARY
Now that you have completed this lesson, let’s review your learning objectives:
1. Describe the theory of behavioural finance.
• In this lesson, we discussed in considerable detail the relatively new field of behavioural finance and its
impact on clients’ investment behaviour and performance. Clients are susceptible to numerous behavioural
biases, and 20 of the most common ones have been described. Advisors have also been provided with a
template showing how they can incorporate behavioural biases in structuring a client’s asset allocation.
• There are two camps in the world of finance: standard finance, which embodies the notion that investors are
inherently rational economic beings; and behavioural finance, which holds that investors are human beings
subject to personal beliefs and biases that may lead to irrational or emotional choices and decisions.

2. Explain the benefits of using the principles of behavioural finance when working with clients.
• Behavioural finance is further divided into two main subtopics. Behavioural finance micro examines
the irrational behaviour of individual investors. It compares irrational investors to the rational investors
envisioned in classic economic theory. Behavioural finance macro describes anomalies or irregularities in the
overall market that contradict the efficient market hypothesis.

3. Explain the drawbacks of traditional risk tolerance questionnaires.

• Traditional risk tolerance questionnaires are limited in their capacity to fully understand clients.
Standard finance is characterized by rules about how investors should behave rather than by principles
describing how they actually behave. Standard finance grounds its assumptions in idealized financial
behaviour while behavioural finance deals with observed financial behaviour.
• The efficient market hypothesis was developed by Professor Eugene Fama of the University of Chicago.
Fama demonstrated that, in a securities market populated by many well-informed investors, investments
will be accurately priced and reflect all available information. There are three forms of the efficient market
hypothesis: strong, semi-strong and weak.
• Successful client–advisor relationships share four fundamental characteristics: the advisor clearly
understands the client’s financial goals; the advisor uses a structured, consistent approach to advising the
client; the advisor delivers what the client expects; and both the client and the advisor benefit from the
relationship.

4. Identify cognitive and emotional client biases.

• Behavioural biases are considered to be systematic errors in financial judgment or imperfections in the
perception of economic reality. They fall into two broad categories, cognitive and emotional, with both
yielding irrational judgments. A cognitive bias can be defined as basic statistical, information processing or
memory errors common to all human beings. Emotional biases originate from impulse or intuition rather
than from conscious calculations.
• Men and women behave quite differently when it comes to investing, and it is important to understand
these differences. For example, men are more overconfident and optimistic than women, whereas women
are more likely to buy and hold. Men are a third more risk tolerant than women, whereas women are
less likely to hold losing investments too long. Men are more likely to allocate too much money to one
investment, and they are more likely to trade too much.

© CANADIAN SECURITIES INSTITUTE

4 • 24 ACCUMULATING WEALTH FOR CLIENTS | COURSE 1

5. Incorporate client bias diagnoses into strategic asset allocation discussions and decisions.
• There are three investor personality dimensions: idealism versus pragmatism, framing versus integrating,
and reflecting versus realism. Combining the elements of these three different dimensions, results in eight
possible investor personality types.
• There are two principles to consider for constructing a best practical asset allocation in regard to client
behavioural biases. The first is to moderate biases in less-wealthy clients and adapt to biases in wealthier
ones. The second is to moderate cognitive biases and adapt to emotional ones.

© CANADIAN SECURITIES INSTITUTE