Defining the 'behavioral investor type' you are dealing with up-front makes it easier to mitigate client behavioral surprises later.
This month's article is the sixth in a series called "Building Better Client Relationships by Understanding Investor Types." This series is intended to help advisors create great working relationships with their clients by taking a step back and understanding the type of person they are dealing with (from a financial perspective).
Individuals are different in the way they process information, vary in the way they behave when faced with a financial decision, and have different risk preferences, so it is essential that advisors interact with each client effectively. This often means that you must change the way you speak to different types of clients even though your advice may be similar across your client base.
Some advisors fail in their tasks not because they don't have technical knowledge of the markets, understand the strategies of investment managers, or have systems that can deliver the best methods of portfolio construction, but rather because they don't understand what is truly important to the client and how to communicate and interact in a way that is meaningful and effective.
As you know by now, I have dedicated a substantial amount of time promoting the benefits of behavioral finance research and making it accessible to large numbers of financial advisors. In my latest book, "Behavioral Finance and Investor Types," my primary objective was to simplify the practical application of behavioral finance by boiling down many of the complexities involved in diagnosing and treating behavioral biases into the simple concept of investor types, which I refer to as "behavioral investor types" or BITs. BITs are defined in large measure by the biases themselves and are categorized in a way that makes intuitive sense and can be easily understood.
Background on the Behavioral Investor Type (BIT) Framework
In my last article, we reviewed the history of personality theories. I hope you now have a perspective on this subject that will provide a frame of reference for the next several articles, which are the "meat and potatoes" of this series.
In this article, we will begin to bridge the gap between mainstream personality theories and introduce the theory behind BITs. Similar to the psychological typing theories that we read about earlier, BITs are models for various types of investors.
This framework has four behavioral investor types: the Preserver, the Follower, the Independent, and the Accumulator. Each of these types will be reviewed in detail--in fact, each will have its own article later in this series.
Before jumping into the nuts and bolts of how to diagnose clients into BITs, it is important for readers to understand the background of their creation. In the next section, I will review my original design for behavioral investor types. In next month's article, I will introduce some upgrades and refinements that I have made to the process to increase the usefulness for both advisors and investors. The original design is still quite relevant; however, I have found the updated process easier to describe and implement.
When I originally created BITs, my intent was to make behavioral finance--a fairly complicated subject--easier to apply in practice for advisors working with clients, and also for investors interested in improving their investment decision-making processes. BITs build on key concepts I outlined in some of my early papers, including one published in the Journal of Financial Planning in March 2005 entitled, "The Future of Wealth Management: Incorporating Behavioral Finance into Your Practice," as well as my book published in 2006, Behavioral Finance and Wealth Management.
BITs were designed to help advisors and investors make rapid yet insightful assessments of what type of investor they are dealing with before recommending an investment plan. The benefit of defining the type of investor you are dealing with up-front is that it's easier to mitigate client behavioral surprises that can result in a client wishing to change his or her portfolio as a result of market turmoil. When advisors create an investment plan that is customized to the client's behavioral makeup, they can limit the number of traumatic episodes that inevitably occur throughout the advisory process by delivering smoother (read: expected) investment results, which can lead to a stronger client relationship.
BITs, however, are not intended to be absolutes, but rather guideposts to use when making the journey with a client. Dealing with irrational investor behavior is not an exact science. For example, an advisor may find that he or she has correctly classified a client as a certain BIT, then realize that the client has traits (biases) of another.
When I first developed the BIT process, I described a method for applying behavioral finance in practice that I now refer to as "bottom-up." This means that in order for advisors to diagnose and treat behavioral biases, they must first test for all behavioral biases in the client before being able to use bias information to create a customized investment plan.
For example, 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 describe 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, and so I developed the Behavioral Alpha method described below, which I call "top down."
Behavioral Alpha Overview
Step 1: Identify a Client's 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 currently does) put his or her capital at risk to build wealth.
Step 2: Administer Risk Tolerance Questionnaire
Once the advisor has classified the investor as active or passive, the next step is to administer a traditional risk tolerance questionnaire to begin the process of identifying which one of the four behavioral investor type categories the client falls into. In the interest of keeping this article to a reasonable length, I have not included a risk tolerance questionnaire, but these are readily available. The advisor's task at this point is to determine where the client falls on the risk scale in relation to where the client falls on the active/passive scale.
Step 3: Test for Behavioral Biases
The third step in the process is to confirm the expectation that certain behavioral biases will be associated with unique behavioral investor types. For example, if an investor is passive, and the risk tolerance questionnaire reveals a very low risk tolerance, the investor is likely to be a Preserver, and the advisor can test for behavioral biases likely to be associated with Preserver BITs.
Once these three steps are completed, the BIT identification is made.
In the next article I will provide illustrations of the BIT identification that follows steps 1 through 3 described above and then give you some updates to the entire process that will set the stage for individual articles on each BIT: the Preserver, the Follower, the Independent, and the Accumulator.