How a client's active/passive and risk tolerance traits can suggest their financial personality.
This month's article is the seventh 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.
The Behavioral Investor Type (BIT) Framework Illustrated
In the last article, we reviewed the three steps involved in identifying a person's BIT. Similar to the psychological typing theories that we discussed in earlier articles, BITs are models for various types of investors. There are four behavioral investor types: the Preserver, the Follower, the Independent, and the Accumulator. Each of these types will be reviewed in detail in its own article later in the series, starting with September's article.
For a quick review, the three steps were:
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) 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 here, 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.