Classify your clients to deal with them more effectively.
For those of you who have been reading my articles, you have undoubtedly noticed that I have been laying the foundation for what we are going to learn in the next five columns: How to advise clients based on their behavioral profile rather than just relying on a risk-tolerance questionnaire. I have developed a method to more easily apply behavioral finance in practice which is based on more than a decade of research called Behavioral Alpha, which classifies investors into one of four behavioral investor types. An overview of this methodology was published in the October 2008 issue of the Journal of Financial Planning. This article explains the framework for Behavioral Alpha, and we will review each of the four behavioral investor types in the next four articles.
The BA methodology builds on key concepts I outlined some of my early papers as well as my 2006 book, Behavioral Finance and Wealth Management . In those works, I outline a method of applying behavioral finance to private clients in a way that I now refer to as "bottom-up." This means that for an advisor to diagnose and treat behavioral biases, he or she must first test for all behavioral biases in the client and then determine which ones a client has before being able to use bias information to create a customized investment plan. In my book I describe 20 of the most common behavioral biases an advisor is likely to encounter, explain how to diagnose these biases, show how to identify behavioral investor types, and finally show how to plot this information on a chart to create the "best practical allocation" for the client. But some advisors may find this bottom-up approach too time-consuming or complex. So here I will summarize a simpler, more-efficient approach to bias identification that is "top-down," a shortcut if you will, that can make bias identification much easier.
The Behavioral Alpha Process: A Top-Down Approach
Step 1: Interview client and identify active or passive traits.
Most advisors begin the planning process with a client interview, which consists mainly of a question-and-answer session intended to gain an understanding as to the objectives, constraints, and past investing practices of a client. Part of this process should include the advisor determining whether a client is an active or passive investor. Through this process you are trying to determine if the client has in the past (or does the client now) put his or her capital at risk to build wealth? Understanding the characteristics of active and passive investors is important because passive investors have tendencies toward certain investor biases, and active investors have tendencies toward different biases. Here is a test that probes the active/passive nature of clients. A preponderance of "A" answers indicates an active investor and "B" answers identify passive investors.
Test for Active/Passive Traits
1. Have you earned the majority of your wealth in your lifetime?
2. Have you risked your own capital in the creation of your wealth?
2. Which is stronger: your tolerance for risk to build wealth or the desire to preserve wealth?
a. Tolerance for risk
b. Preserve wealth
3. Would you prefer to maintain a degree of control over your investments or prefer to delegate that responsibility to someone else?
a. Maintain control
4. Do you have faith in your abilities as an investor?