4 tips for advisors using behavioral portfolio construction

Posted by Miranda Marquit, Guest Contributor on Sep 23, 2019 11:02:11 AM

Increasingly, we hear about behavioral economics — the way humans make financial decisions based on their biases. Today’s advisor needs to be well-versed in ways biases can impact their clients and create portfolios that fall in line with what is known about behavioral economics.

Creating these portfolios can be challenging, though. After all, many clients panic at a stock market drop, and it can be tough for advisors to help them stick to a long-term investment plan. Other biases can lead to clients not understanding the importance of adding appropriate risk to a portfolio or encourage them to trade too much, destroying portfolio efficiency.

Why behavioral portfolio construction is important

“As an advisor, learning how to identify client biases and understand behavioral economics principles to construct portfolios can be a good way to add value to your services,” says Devin Ekberg, CFA, CPWA, CIMA, and Chief Learning Officer and Managing Director of Content Development at the Investments & Wealth Institute.

He points out that many advisors are being asked to offer more personalized services designed to tailor offerings to individual clients. Omar Aguilar, Ph.D., CIO of Equities and Multi-Asset Strategies at Charles Schwab Investment Management, Inc. echoed this in a recent Investments & Wealth Monitor [DC1] article saying, “The portfolio construction process is about balancing what clients want with what clients need to meet their investment objectives.”

With the rise of robo advisors, some clients are looking for advisors that can set themselves apart and create added value. Behavioral portfolio construction not only sets an advisor apart, but it can also help a client see better long-term results.

Some of the important aspects of behavioral science that can influence the client-advisor relationship include:

  • Trust
  • Loyalty
  • Paradoxes related to choices
  • How biases impact investment returns
  • Planning and the importance of addressing biases

When advisors understand more about the intersection of behavioral science and finances, they are able to build better rapport with clients, and better serve them.

For advisors looking to incorporate behavioral portfolio construction into their practice, here are four tips that can make a huge difference.

1. Understand your clients’ behavioral biases

The first step is to understand the basics of behavioral economics and the biases that might be influencing clients. This might require a little extra research as you learn what cognitive and emotional biases are common — and how they affect investment outcomes.

There are a variety of commonly recognized biases:

  • Anchoring bias – Tendency to focus on specific reference point when making investment decisions.
  • Confirmation bias – tendency to seek information that reinforces their perception
  • Familiarity/home bias – make decisions based on own/familiar experience. (e.g., preference to invest in familiar/U.S. domiciled companies)
  • Loss aversion – Clients playing it safe/taking less risk then they can tolerate.
  • Recency Bias – easily influenced by recent news events or experiences (believe recent events will continue in the future).

According to the recently released BeFi Barometer 2019 research survey sponsored by Charles Schwab Investment Management, Inc. in collaboration with the Investments & Wealth Institute and Cerulli Associates, the most prevalent biases observed among clients –recency bias (35%) was the most common bias, followed by loss aversion. (26%), confirmation bias (25%), familiarity/home bias (24%) and anchoring bias (24%).

Another way to learn about these biases, is to surround yourself around behavioral experts.

The Institute offers a variety of online and on-demand courses that are right at your fingertips: Applied Behavioral Finance, The Behavioral Advisor and Behavioral Finance for Advisors. You can also attend the annual behavioral finance forum, where you are immersed by a group of academics, practitioners and researchers. Once you get a feel for your clients’ biases, you can use that information to build better portfolios.

“Understanding the latest research and insights from behavioral science can help you be a better advisor,” says Ekberg.

2. Adapt client behavioral biases at a higher net worth

For clients with a higher net worth, Ekberg suggests it’s a good idea to adapt to their behavioral biases. For example, it’s possible to adjust a client’s asset allocation to account for their emotional and cognitive biases. You might not always be able to change a client’s biases, so it becomes vital to identify client biases and use strategies designed to offset them when managing the portfolio.

When a client has a higher level of wealth, it becomes important to understand how to adapt the portfolio and create an investing plan that incorporates the realities of behavioral economics. An advisor who can successfully do this will see better results in the long-term, as well as in the short-term.

3. For lower levels of wealth, moderation is key

Because behavioral portfolio construction isn’t one-size-fits-all, it’s important to change the approach a little bit for those who might not have higher levels of wealth.

“Seek to reduce or eliminate biases at lower wealth levels,” says Ekberg. “This approach can help you educate your clients and help them grow wealth more effectively over time.”

When working with clients, it’s important to understand their concerns and their goals. As a trusted advisor, your ability to help your clients make better decisions is key to long-term success. A behavioral approach to portfolio planning is good for your clients and for your practice, no matter how much wealth they have when they start working with you.

4. Asset allocation should be dynamic

Portfolio construction and ongoing portfolio maintenance isn’t a set-it-and-forget-it proposition. Instead, Ekberg points out, asset allocation should change as a client matures. Generational differences make a big difference, according to the BeFi Barometer 2019. The survey indicated that Generation X clients (64%) are most likely to be subject to recency bias compared to Baby Boomers (52%) and Millennials (33%) – while loss aversion bias is most prevalent among Baby Boomers (75%) and Silent Generation clients (71%), compared to Generation X (22%) and Millennials (20%).

As clients progress through life, their needs and risk tolerances change. Portfolio construction is an ongoing process that takes this reality into account. On top of that, it’s important to recognize that client biases can change as well. Including the behavioral component on top of the straight financial realities is what takes portfolio management to the next level.

Sometimes it’s not just about accommodating different life milestones and events. Many clients undergo changes to their cognitive and emotional states and develop new biases as old biases disappear. Behavioral portfolio construction takes into account the fact that sometimes adjustments need to be made based on new or changing biases.

“However, even as asset allocation should be dynamic, it’s important to realize that portfolio changes should be more proactive,” says Ekberg. “While reactive changes are sometimes necessary, an understanding of behavioral economics can help you approach a portfolio in a proactive way that has greater benefits.”

Bottom line

Understanding behavioral portfolio construction is an ongoing process. It starts at the outset of the advisor-client relationship and continues throughout a client’s investing lifespan. The more adept an advisor is at understanding the principles of behavioral economics and their clients’ biases, the more likely they are to have success in managing portfolios.

“Advisors that can accurately assess the behavioral needs of their clients at the onset, during the portfolio construction process. This will allow them to be more prepared to deal with behavioral biases as they arise,” says Ekberg. “They will also be better able to help a client stick with their long-term plan.”


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