HNW investor mindset changes dramatically

If there’s one group of clients whose outlook on the markets has changed, it’s the high-net-worth (HNW) group. Studies are showing that the biggest seismic shift in investor attitude during the downturn is among this group. This means, advisors may have to alter their portfolio strategies.

Before the downturn, HNW investors generally had a higher propensity for risk-taking, notes private client management expert Stephen Horan, head of professional education, content and private wealth, with the Virginia-based CFA Institute. They could afford to lose money, so they were more apt to stay invested and invest in products that provide a nice compensation stream for advisors.

“HNW clients are now more conservative than the average investor. That’s despite the fact that investors as a whole have become more conservative,” Horan says. “Their changing conservatism has become more pronounced.”

Horan cites a report released this year by Cerulli Associates which found that the average household that described itself as financially conservative increased from 32% to 35%. But for HNW investors, that number jumped from 17% to 38%.

Moving to cash and fixed income isn’t the answer, however. What has been working is a mental accounting or “bucket” approach to portfolio management, Horan says. This is a concept pioneered by internationally renowned behavioural finance expert Meir Statman, the Glenn Klimek professor of finance at the Leavey School of Business at Santa Clara University.

Statman, who works as a special consultant with Canadian advisory firm Wellington West, is a proponent of modern portfolio theory, but he believes that managers need to create separate investment buckets for different investment goals. Within those buckets, the advisor creates self-contained investment strategies suited to the risk tolerance of those goals.

Very simply, a bucket of money may be necessary for living expenses in retirement. Mentally, the client will not be able to accept the loss of this money, so it’s put into a very conservative portfolio. Client risk tolerance is really pegged to individual goals, so an advisor who appropriately tailors goals to risk tolerance will likely have the client in a better state of mind coming out of a downturn.

Statman says investors of all stripes don’t correlate the concept of risk and return appropriately. There is less risk aversion during bull markets accompanied by confidence about returns. The opposite is true during a downturn. Neither state of mind indicates what investors’ true risk tolerance would be.

“People don’t have in their minds that high returns and high risk are related,” he explains. “If the market seems good, investors tend to believe the market offers high returns and low risk. During a downturn, they believe it offers only low returns and high risks,” he says. “What you’ve seen is that in 2007 or in 1999, people thought the market was beautiful, [with] high returns and low risk. They didn’t tell you that their risk was low.”

According to Statman, with the bucket approach, the worst feelings of loss can be avoided during a downturn because vital asset pools are protected. If the client has discretionary goals and the money to fund them — which HNW clients generally do — those buckets can deliver the higher rate of returns that accompany greater risks.

It’s a way to keep the HNW ego in check, which plays an important role in investment behaviour.

“Having spoken to people who have $15 million or more, I can see that they are really quite injured and really worrying about the future and wondering about what will happen with high inflation,” Statman says. “They have more money than they can spend in their lifetimes. The damage is really to their egos than to their livelihoods. That damage can be substantial.”

Horan says he’s seeing more private wealth managers use strategies like Statman’s to reassess client risk tolerance. Private wealth managers are going back to clients, ranking and identifying certain investment objectives, and then ranking those objectives by risk tolerance.

“[Clients] have particular obligations for their assets and identified and ranked some of those obligations. For example, a client may say it is important to have money to send their kid to school and to provide healthcare for the family,” he says. “They’ve decided to separate those obligations and decide which assets they want to use for those obligations. They’ll use low-risk assets for the very important obligations. They’ll take risk with the remainder of that portfolio.”

Horan says advisors can also work to alleviate client concerns by adding value to factors that can be controlled. The most profound and effective cost savings come from tax-planning expertise.

“Good advisors can control fees and taxes,” he says. “You don’t have complete control over taxes, but you can manage more of [a client’s tax outcome], so there is greater focus on tax-aware investment strategies among private wealth managers.”

(08/28/09)