This is the second article in a series focusing on behavioral investor types and intended to help advisors strengthen their relationships with their clients by helping them better understanding clients' financial personalities. Once advisors understand the various investor types at play, they can adjust their advisory approach for each type.
There are four behavioral investor types. We'll publish case studies over the next several months.
No. 1: Preserver A preserver is an investor who places a great deal of emphasis on financial security and preserving wealth, rather than taking risks to grow wealth. Such investors are guardians of their assets, and they take losses very seriously. Preservers are often deliberate in their decisions and sometimes have difficulty taking action with their investments, out of concern that they may make the wrong decision or take on too much risk. They instead prefer to avoid making decisions and sticking to the status quo. Preservers often obsess over short-term performance in both up and down markets (but mostly down markets), and they also tend to worry about losing what they had previously gained. This behavior is consistent with how preservers have approached their work and their personal lives--in a deliberate and cautious way.
Older investors often behave in a way that's aligned with the preserver behavioral investor type. This is natural. As we age, certainty of cash flow becomes paramount. As such, it is common to find preservers focusing their wealth on taking care of their family members and future generations, especially funding life-enhancing experiences such as education and home buying. Because the focus is on financial security, Preserver biases tend to be dominated by emotion (relating to how they feel) rather than focusing on cognitive aspects (relating to how they think).
Wealth level may also influence preserver behavior. Although not always the case, many preservers that have gained wealth want to preserve it, and they therefore change their attitude toward risk after gaining wealth. This is especially true when an investor has been through a crisis that threatened his or her wealth (like in 2008, when the S&P 500 dropped 37% for the year). The emotional biases that can affect preservers’ ability to attain their financial goals are loss aversion, status quo, and endowment biases. Preservers can also display certain cognitive biases that relate to the same orientation, namely anchoring and mental accounting.
No. 2: Follower A follower investor 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 popular--to make their investment decisions. Often their decision-making process is without regard to a long-term plan. They sometimes trick themselves into thinking they are adept or talented in the investment realm when an investment decision works out, which can lead to unwarranted risk seeking behavior. Since they don't have their own ideas about investing, Followers also may react differently when presented more than once with the same investment proposal; that is, the way something is presented (framed) can make them think and act differently. They also may regret not taking part in the latest investment fad, and may 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 pursue all of them. Some followers don't like, or even fear, the task of investing, and many put off making investment decisions without professional advice; the result is that they maintain, often by default, high cash balances. Followers generally comply with professional advice when they get it, and they try to educate themselves financially.
Followers' biases tend to be cognitive, relating well to how they think, rather than emotional, relating to how they feel. Biases of followers are recency, hindsight, regret aversion, framing, and cognitive dissonance.
No. 3: Independent An independent investor has original ideas about investing and likes to get involved in the investment process. Unlike followers, independents are quite engaged in the financial markets, and they may have unconventional views on investing. This "contrarian" mindset, however, may cause independents not to believe in following a long-term investment plan. With that said, many independents can and do stick to an investment plan to accomplish their financial goals. At their essence, independents are analytical, critical thinkers who make many of their decisions based on logic and their own gut instinct. They are willing to take risks and act decisively when called upon to do so. Independents can accomplish tasks when they put their minds to it; they tend to be thinkers and doers as opposed to followers and dreamers.
Unfortunately, some are prone to biases that can torpedo their ability to reach goals. For example, they may act too quickly, without learning as much as they can about their investments before making them. For example, they may mistake reading an article in a business news publication for doing original research. In their half-ready, full-on pursuit of profits, they may leave some important stones unturned that could trip them up down the road. Independents' risk tolerance is relatively high, and so is their ability to understand risk. Independents are realistic in understanding that risky assets can, and do, go down. However, when their investments go down they don't like to admit that they were wrong, or that they made a mistake (sound familiar?). Independents often do their own research and don't feel comfortable with an investment until they have confirmed their decision with research or some form of corroboration. They are comfortable collaborating with advisors, though typically using advisors as sounding boards for their own ideas. Independents are often comfortable speaking the language of finance and understand financial terms. They aren't afraid to delve into the details of investments, including the costs and fees of making investments.
The behavioral biases of Independents are cognitive conservatism, availability, confirmation, representativeness, and self-attribution.
No. 4: Accumulator The accumulator is an investor who is interested in accumulating wealth and is confident that he or she can do so. These clients have typically been successful in some business pursuit and believe in themselves enough that they will be successful investors. As such, they often like to adjust their portfolio allocations and holdings to market conditions and may not wish to follow a structured plan. Moreover, they want to influence decision-making or even control the decision-making process, which potentially can diminish an advisor's role. At their core, accumulators are risk takers and are firm believers that whatever path they choose is the correct one. Unlike preservers, they are in the race to win--and win big. And unlike the followers, they rely on themselves and want to be the ones steering the ship. And unlike individualists, they usually dig down to the details rather than forge a course with half the information that they need.
Unfortunately, some accumulators are susceptible to biases that can limit their investment success. For example, they may be too confident in their abilities. Since they are successful in business or other pursuits, why shouldn't they be successful investors? And overconfidence sometimes leads them to think they can control the outcome of the investment even though it may be full of unknown risks. Accumulators can also let their spending get out of control at times due to the "wealth effect" of having created assets that can lead to lifestyles that are more extravagant than prudent. Accumulators also may make investments based on how the opportunities they come across resonate with their personal affiliations or values.
Accumulators' risk tolerance is quite high, but when things go the wrong way (they lose money), discomfort can be very high. This discomfort may arise not only from financial loss but also from the blow to their confidence and the realization that they cannot control the outcomes of investments. Some accumulators can be quite difficult for advisors to build close relationships with, because these clients are making their own decisions rather than relying on the advice and counsel of their advisor. These clients are entrepreneurial and often the first generation to create wealth, and they are even more strong-willed and confident than Individualists. Left unadvised, accumulators often trade too much, which can be a drag on investment performance. Furthermore, they are quick decision makers but may chase higher risk investments than their friends. If successful, they enjoy the thrill of making a good investment. Some accumulators can be difficult to advise because they do not believe in basic investment principles such as diversification and asset allocation. They are often hands-on and wish to be heavily involved in the investment decision-making process. The behavioral biases of accumulators are overconfidence, self-control, affinity, outcome, and illusion of control.
Michael M. Pompian, CFA, CAIA, CFP, is the founder and chief investment officer of Sunpointe Investments, an investment advisor to family offices based in St. Louis, Missouri. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients. Contact Michael at email@example.com.
The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.