This post by Michael Pompian first appeared on Morningstar.com
Some advisors do a less than optimal job in their advisory roles, not because they lack technical knowledge of the markets or because they lack and understanding the strategies of investment managers or because they lack the systems that can deliver the best methods of portfolio construction. Rather, these advisors lack an understanding of what is truly important to their clients and don't know how to communicate and interact in a way that is meaningful and effective.
This is the first in a series focusing on behavioral investor types. This series is 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.
The first step provides background on how I developed behavioral investor types. To gain an appreciation for the foundation of the concept of a behavioral investor type, it is essential that we explore how personality types were developed.
Personality Type Theories
While there are many different theories of personality, what is meant by the term "personality?" Personality is made up of the characteristic patterns of thoughts, feelings, and behaviors that make a person unique. It arises from within the individual and remains fairly consistent throughout life.
Behavioral investor types are most strongly influenced by the Type Theories; they're a classification scheme similar to Hippocrates' four original types, the Kiersey Types, and the Myers-Briggs Types.
Type theories take us all the way back to ancient Greece, around 400 B.C., to the work of Hippocrates. The great physician believed that people could be "typed" into four distinct categories: Melancholic, Sanguine, Choleric, and Phlegmatic after the bodily fluids that were then thought to influence personality. Each category was also linked to one of the four elements--fire, air, water, and earth--collectively referred to as the "humors."
Today, Hippocrates' personality types are called Guardians (fact-oriented), Artisans (action-oriented), Idealists (ideal-oriented), and Rationalists (theory-oriented).
These humors encompass the most basic, underlying characteristics of what we today refer to as "personality." No one's actions are entirely "rational" or "theory-based," and no one is solely "action-oriented." Rather, most people are a combination of many of these humors, but in varying proportions. For example, your spouse may be a rationalist and you may be more action-oriented, but obviously neither of these characteristics comprises your entire personalities.
This is true of financial personality, as well. Personality type schemes tend to overgeneralize about personality traits (since people are rarely only one type of person), but they are a useful tool for organizing one's thoughts about how to compare one type of person versus another.
The Behavioral Investor Type Framework and Behavioral Alpha
Similar to the psychological typing theories that we just read about, behavioral investor types 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 the next article.
Behavioral investor types are assigned through a process called Behavioral Alpha, which is covered more deeply in my book, Behavioral Finance and Investor Types.
The process is as follows:
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 of the objectives, constraints, and past investing practices of a client. As part of this step, advisors should determine whether a client is an active or passive investor. In a nutshell, try to figure out 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
The next step is to administer a traditional risk tolerance questionnaire to identify which one of the four behavioral investor type categories the client falls into. 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 behavioral investor types. Once these three steps are completed, the identification is made.
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 michael@sunpointeinvestments.com.