Maximize client interaction by spotting clients' inclinations.
Last month's article introduced the 20 most-common behavioral biases that financial advisors are likely to encounter when working with their clients. Readers might have been overwhelmed with having to learn so many. Subsequent articles will, however, break out certain kinds of investors and give examples of the biases most frequently encountered, and later on readers will get information on how to use this knowledge in a practical setting.
Just as biases are the buildings blocks of the practical application of behavioral finance, assigning biases to certain risk-tolerance levels is the foundation of classifying investors into behavioral investor types. By understanding what type of client you are dealing with and the behaviors you will work with during the client relationship (especially during times of market turmoil), advisors will be armed with the skills they need to get inside the heads of their clients and anticipate what might go wrong rather than react blindly to a situation gone wrong. Ultimately, your job is to create behaviorally modified investment programs to which clients can comfortably adhere in order to meet their long-term financial goals. Before we get into the biases of conservative clients, let's review some tips on the client diagnostic process.
Biases and the Client Diagnosis
Most experienced financial advisors begin the financial planning process with a client interview. This consists mainly of a question-and-answer session intended to gain an understanding of the objectives, constraints, past investing practices, and--importantly--the risk tolerance of a client. The usual tool used to assess risk tolerance is a risk-tolerance questionnaire. Along the way, the advisor should be ascertaining whether a client is an active or a passive investor. Has the client wished (or does the client now wish) to put his or her capital at risk to build wealth? It is important to make a distinction between investing in a diversified portfolio and risking capital. Some examples of risking capital are building companies (big or small), investing in real estate using leverage beyond a primary residence, or working for oneself rather than for a large company. The idea of classifying investors as either active or passive is not new. In 1978, Marilyn MacGruder Barnewall classified investors by asking this basic question: Did an investor risk personal financial assets to create their own wealth over a lifetime? If not, these investors were identified as "passive." If so, they were dubbed "active." (Barnewall, M. 1987. "Psychological Characteristics of the Individual Investor." in William Droms, ed. Asset Allocation for the Individual Investor. Charlottsville, Va: The Institute of Chartered Financial Analysts.) It is important to understand the characteristics of active and passive investors because passive investors have tendencies toward certain investor biases, as do active investors. Here's a brief discussion of the characteristics of active and passive investors, followed by a test you can administer to clients that can help you determine their active or passive nature.
Passive investors are those investors who become wealthy by inheritance or by risking the capital of others such as stockholders, investors, or taxpayers. Passive investors usually have a high need for security and a low-to-moderate tolerance for risk. Examples of passive investors include second- or multi-generational inheritors, corporate executives, lawyers, accountants, politicians, and bankers. Active investors earn wealth during their own lifetimes. They have been actively involved in the wealth creation and have risked their own capital in achieving their wealth objectives. Active investors usually have a higher tolerance for risk than they have need for security. Related to their high risk tolerance is that active investors prefer to maintain control of their own investments. Their tolerance for risk is high because they believe in themselves. They get very involved in their own investments and like to do due diligence on contemplated investments. They are often difficult clients.
Active or Passive?
The ideal situation is for the advisor to be able to identify a client or potential client's active or passive nature subtly, through conversation, without administering a questionnaire. If the advisor prefers, here is a simple test that can either be administered by the advisor to the client, or that the advisor can fill out based on knowledge of the client.
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?
3. Which is stronger: your tolerance for risk to build wealth or the desire to preserve wealth?
a. Tolerance for risk
b. Preserve wealth