Followers often overestimate their risk tolerance in pursuit of the latest trendy investment.
This month's article is the 10th 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.
There are four behavioral investor types: the Preserver, the Follower, the Independent, andthe Accumulator. In the last article, I reviewed the Preserver BIT. In this article I will review the Follower BIT.
The Follower Behavioral Investor Type
A Follower describes an investor who is passive and often lacks interest in and/or has little aptitude for money or investing. Furthermore, Follower investors typically do not have their own ideas about investing. Rather, they may follow the lead of their friends and colleagues, or whatever general investing fad is occurring, to make their investment decisions. Often their decision-making process is without regard to a long-term plan.
Followers sometimes trick themselves into thinking they are smart or talented in the investment realm when an investment decision works out, which can lead to unwarranted risk-seeking behavior. Because they don't tend to have their own ideas about investing, they also may react differently when presented more than once with the same investment proposal; that is, the way something is presented or framed can make them think and act differently. They also may regret not being in the latest investment fad and end up investing at exactly the wrong time, when valuations are the highest.
One of the key challenges of working with Followers is teaching them how to refrain from overestimating their risk tolerance. An investment may appear so compelling that they jump in without considering the risks. Advisors need to be careful not to suggest too many hot investment ideas: Followers will likely want to do all of them.