Morningstar, the mutual fund rating company, publishes MorningstarAdvisor, a magazine for financial advisors that covers a range of topics. One topic is understanding the psychology of different investor types, how to recognize them, and how to work with those clients. The current issue has an article on aggressive investors. This one really struck a cord with me as I have clients that fit this model perfectly, to their detriment of late.
Aggressive investor biases are mainly emotional which is very important to recognize when working with these investor-types. In the current market environment, many aggressive investors, with equity allocations of up to 60% or even more, have suffered serious losses with equity markets down almost 40% year-to-date through mid-December 2008. The velocity with which these losses have occurred has shocked and dismayed aggressive investors. What many advisors are learning is that aggressive investors like to take risk when the markets rise, but clearly don’t like it when markets swoon.
I have this client. They don’t remember the warnings I made and now feel I should have timed the market for them with precision.
As a reminder, aggressive clients are typically active investors, meaning that they have been actively involved in wealth creation, risking their own capital to achieve their wealth objectives. This makes them naturally prone to taking risk in their investment portfolios. Active investors have a higher tolerance for risk than they have need for security. As such, aggressive clients naturally fall in the high end of the risk tolerance scale and primarily have emotional biases driving their investing decisions. By way of review, emotions are physical expressions, often involuntary, related to feelings, perceptions or beliefs about elements, objects or relations between them, in reality or in the imagination. Often, because emotional biases originate from impulse or intuition rather than conscious calculations, they are difficult to correct. This is especially true with aggressive investors.
The issue I see most often with aggressive investors is too much self confidence.
Overconfidence is best described as unwarranted faith in one’s own thoughts and abilities – which contains both cognitive and emotional elements. Overconfidence manifests itself in investors’ overestimation of the quality of their judgment. Many aggressive investors claim an above-average aptitude for selecting stocks; however numerous studies have shown this to be a fallacy. For example, a study done by researchers Odean and Barber showed that after trading costs (but before taxes), the average investor underperformed the market by approximately 2% per year because of unwarranted belief in their ability to assess the correct value of investment securities.