Behavioral Biases Surrounding Concentrated Positions

Portfolio managers, financial advisors, and individual investors are all susceptible to allowing common behavioral biases impact their decision making. Financial advisors can add value by helping their clients objectively assess their decisions that may be influenced by behavioral biases. While behavioral biases can impact virtually every investment decision, this post will explore behavioral biases as they relate to financial planning around concentrated positions.

Endowment Bias

The endowment effect refers to an emotional bias that causes individuals to value a currently owned object higher, often irrationally, than its market value. In the wealth management world, this bias usually emerges in the context of concentrated positions – which typically arise equity/option grants from employment, entrepreneurship, a successful investment, or inheritance.

Status Quo Bias

The status quo bias refers to the tendency to prolong and maintain the current situation. Like the endowment bias, it can materialize in the context of concentrated positions. Individuals will often avoid making changes, even when making that change is advantageous to their financial situation.

Overconfidence Bias

Overconfidence bias is a tendency to hold a false and misleading assessment of our skills, intellect, or talent. The danger of this is that it increases the odds of an investing mistake, usually in the form of not being cautious enough.

Strategies

How can advisors help their clients overcome one or more of these biases? The role of the advisor should be helping clients formulate an objective summary risks and trade-offs in decisions surrounding concentrated positions. When the client has made an objective evaluation, they are much more likely to make an appropriate decision.

This process often begins with initial discovery questions:

• What is the primary objective for your overall portfolio and this holding?

• What is the worst-case scenario for this holding? Are you OK with this outcome?

• If you had cash equal to the value of the holding instead, how would you allocate it?

• Which is a worse outcome – selling a holding that goes on to outperform, or continuing to hold and seeing it underperform?

• What are the tax consequences of selling now and do you have an opinion on how they will evolve from a policy perspective going forward?

By starting with these fact-finding questions, an advisor can help a client work through potential behavioral biases and articulate an objective set of pros/cons regarding how to manage a concentrated position. The answer may not always be to diversify - but while concentration is sometimes necessary to create wealth, it is not certainly necessary to preserve it. You only have to get rich once.