Behavioral Finance Case Studies: Two Investors, Two Very Different Problems

Chapter 25 is where all the theory from the entire book gets applied to actual people. Well, fictional people. But they feel real enough that you will probably recognize yourself or someone you know in one of them.

Pompian gives us two case studies that represent opposite ends of the spectrum. One is a wealthy guy with emotional biases. The other is a less wealthy woman with cognitive biases. And the advisor handles them completely differently.

Mr. Nicholas: The Rich Guy Who Thinks He’s a Great Investor

Mr. Nicholas is 59 years old, single, earns $600,000 a year as a pharmaceutical marketing executive. His portfolio is worth about $4 million, mostly from some lucky biotech bets and company stock options. He has homes in Geneva and New Jersey. He lives well but mostly within his income.

Here’s the problem. His advisor, Spencer, ran a proper analysis and recommended a portfolio of 50% stocks, 40% bonds, and 10% cash. But Mr. Nicholas has been sitting at nearly 80% stocks, with 35% of that in his own company’s stock. And he has been ignoring Spencer’s advice for months.

Spencer gives Mr. Nicholas a behavioral bias questionnaire and finds three main biases:

Regret aversion. Mr. Nicholas is afraid of selling a winner too early. He would rather hold and hope than sell and potentially miss out on more gains. He also picks “safe” big-name stocks not because they are better investments, but because he would feel less foolish if they failed. “At least everyone else lost money too.”

Overconfidence. He thinks the 2008 credit bubble was “somewhat easy” to predict. He expects his equity returns to be “well above” the historical 9% average. He believes he has “a fair amount of ability” to pick winning investments. Classic overconfidence pattern.

Self-control. When it comes to buying a car, he splurges on top of the line models. He hardly ever saves for retirement and spends most of his disposable income. He lives in the moment.

All three of these are emotional biases. They come from feelings, not from faulty logic.

What Spencer Does with Mr. Nicholas

So Spencer has to decide: moderate or adapt?

Looking at Guideline 1, Mr. Nicholas is wealthy. $4 million plus a $600,000 salary, and his retirement spending goal is $150,000 a year. He is not going to outlive his money even with a suboptimal portfolio. Low standard of living risk. This says: adapt.

Looking at Guideline 2, his biases are emotional. Emotional biases are hard to change with education alone. This also says: adapt.

Both guidelines point the same direction. So Spencer adapts.

The final recommendation: 60% stocks, 30% bonds, 10% cash. That is 10% more in stocks than the “rational” portfolio suggested. Spencer is basically saying “I know you want more stocks, and you can afford to have more stocks, so let’s give you a portfolio you will actually stick with.”

But Spencer is not just giving in completely. He also recommends Mr. Nicholas reduce his company stock position by 50% (because having 35% of your wealth in one stock is genuinely dangerous) and reduce spending if possible.

Here’s the thing I find smart about this approach. Spencer is not fighting a battle he will lose. If he insists on the 50/40/10 split, Mr. Nicholas will probably just ignore him again. The 60/30/10 split is a compromise that gets Mr. Nicholas from 80% stocks to 60% stocks. That is a huge improvement, and Mr. Nicholas will actually do it because it still feels aggressive enough for his taste.

Mrs. Alexander: The Careful Woman Who’s Too Careful

Mrs. Alexander is 85 years old, a widow from Australia. Her entire income comes from a $1.5 million investment portfolio (about $90,000 per year) plus a small $10,000 government pension. She has no other income sources. She grew up in a lower-middle-class family with six siblings where money was always tight.

Her entire portfolio is in government bonds and cash. 100% bonds. Nothing else.

Her advisor Spencer has known her for 10 years and has been trying to get her to diversify. The only thing she has agreed to is buying some sovereign bonds to slightly increase returns. She is stubborn and not very financially sophisticated, but she is willing to meet regularly over tea to discuss things.

Spencer’s analysis reveals three biases:

Anchoring. In a scenario about selling a house after property prices drop 10%, Mrs. Alexander only lowered her price by 5%. She is anchored to the original number and cannot fully adjust to new information.

Mental accounting. She separates her money into different “buckets” for income, gifts to grandchildren, bills, and so on. Instead of looking at her total financial picture, she thinks in categories.

Loss aversion. Given a choice between a guaranteed $400 gain and a 25% chance of $2,000, she takes the guarantee. Given a choice between a guaranteed $400 loss and a 50/50 chance of losing $1,000 or nothing, she takes the gamble. Classic loss aversion pattern: risk-averse with gains, risk-seeking with losses.

Two of these (anchoring and mental accounting) are cognitive biases. Loss aversion is emotional, but the cognitive biases dominate.

What Spencer Does with Mrs. Alexander

The “rational” portfolio from the optimizer says 75% bonds, 15% stocks, 10% cash. Mrs. Alexander wants 100% bonds.

But here’s the problem. Spencer’s financial planning software shows that with 100% bonds, Mrs. Alexander will likely outlive her money. After inflation and taxes, her purchasing power will erode year by year. This is not a theoretical risk. This is a real threat to an 85-year-old woman with no other income.

Guideline 1: Her wealth level is moderate but not high, and her standard of living risk is significant. This says: moderate.

Guideline 2: Her dominant biases are cognitive (anchoring, mental accounting). Cognitive biases can be corrected with education. This also says: moderate.

So Spencer moderates. The recommendation: 75% bonds, 15% stocks, 10% cash. Exactly what the rational optimizer suggested. No behavioral adjustment at all.

Why? Because Mrs. Alexander cannot afford a behavioral adjustment. She needs those stock returns to keep her money growing enough to last. And since her biases are cognitive, Spencer can work with her over time to help her understand why some stock exposure is necessary.

Spencer also commits to a continuing program of education about the risk of outliving one’s assets.

What I Take Away from This

The contrast between these two cases is perfect. Same advisor, same framework, completely different outcomes.

Mr. Nicholas gets a portfolio that is MORE aggressive than the rational one because he is rich enough to handle the risk and too emotionally driven to accept a conservative portfolio.

Mrs. Alexander gets exactly the rational portfolio because she cannot afford to indulge her biases and her biases are the kind you can educate away.

For me, the biggest lesson from this chapter is that there is no one-size-fits-all approach. Two people with the same advisor and the same access to information get different portfolios because they have different brains and different financial situations. And that is not a bug. That is the whole point.

If you find yourself in the Mr. Nicholas category (wealthy, emotionally biased), give yourself permission to have a slightly “imperfect” portfolio that you will actually follow. If you are more like Mrs. Alexander (tighter finances, thinking errors), work on educating yourself out of those cognitive traps. Your financial future may depend on it.

Previous: Asset Allocation

Next: Investor Type Diagnostic

This is a retelling of “Behavioral Finance and Wealth Management” by Michael M. Pompian, 2nd Edition (Wiley, 2012). ISBN: 978-1-118-01432-5. Start from the beginning.