Lecture 7: The Uses and Limitations of Classifying Investors into Types & How behavioral factors affect adviser-client relationships

active investor

Have usually risked their own capital to gain wealthy entrepreneurs). They usually take an active role in investing their own money. More experienced, more comfortable with risk, particularly while they feel in control of that risk.

characteristics of active investor

- Higher tolerance for risk than they have need for security

- When lose sense a loss of control, risk tolerance drops quickly

- Involved in their own investments, to the point they gather tremendous amounts of information about the investment

passive investor

Have NOT risked their own capital to gain wealth. May have less education about investing & risk averse/cautious. Passive investors will either be inheritors or long-term savers who have saved $ from a steady job

characteristics of passive investors

- Became wealthy passively

- Inheritance or by risking the capital of others

- Have greater need for security than they have tolerance for risk

Ex. corporate executives, lawyers with large regional firms, certified public accountants with large CPA companies,

- Higher security and need for low risk tolerance

psychographic characteristics that are relevant with regard to individual strategy and risk tolerance

personality, values, attitudes, and interests

Bailard, Biehl, and Kaiser Five-Way Model; two aspects/ elements

- How confidently the investor approaches life, regardless of whether it is his approach to his career, his health, or his money (emotional choices)

- Methodical, careful and analytical in his approach to life whether he is emotional, intuitive, and impetuous

Bailard, Biehl, and Kaiser Five-Way Model; two main axis

- vertical axis = Confident axis: level of CONFIDENCE vs ANXIOUS in making decisions

- Horizontal = CAREFUL vs IMPETUOUS with your decisions

Bailard, Biehl, and Kaiser Five-Way Model; 5 types of investors:

Individualist

Adventurist

Celebrity

Guardian

Straight arrow

Individualist

- confident and careful

- rational info- processor

- willing to listen and advise

- pleasant to advise because they will listen and process information rationally

adventurist

- challenge for an investor

- confident and impetuous

- likes to make own decisions

- stubborn and unwilling to listen

- risk taker, may hold concentrated postions

gaurdian

- become when your older

- anxious and careful

- concerned wealth professional

- looks to protect assets

- make seek advice to someone they think is more knowledgable

celebrity

- likes to be the center of attention

- anxious and impetuous

- has investment options but seeks and takes advice

- recognizes own limitation

Bailard, Biehl, and Kaiser Five-Way Model; Model is not pure types and people can be __________ of these variable types

combinations

Pompian Behavioural Model; 4 step process

1. Interview the client to determine if he/she is active or passive as an indication of his/her risk tolerance.

2. Plot the investor on a risk tolerance scale.

3. Test for behavioural biases.

4. Classify the investor into one of the BITs.

Pompian Behavioural Model uses ________- approach

bottoms up

Pompian Behavioural Model 4 investor types

- Passive Preserver

- Friendly Follower

- independent Individualist

- Active Accumulator

The Pompian Behavioural Model

Most common emotional biases exhibited

- Passive Preserver: Endowment, loss aversion, status quo, regret aversion.

- Friendly Follower: Regret aversion.

- Independent Individualist: Overconfidence, self-attribution.

- Active Accumulator: Overconfidence, self-control, affinity bias.

The Pompian Behavioural Model

Most common cognitive biases exhibited

Passive Preserver: Mental accounting, anchoring and adjustment.

Friendly Follower: Recency, hindsight, framing, cognitive dissonance.

Independent Individualist: Conservatism, availability, confirmation, representativeness.

Active Accumulator: Illusion of control, outcome bias.

Passive preserver; basic type and risk tolerance

Basic type: Passive

Risk Tolerance level: Low

passive preserver characteristics

- Value financial security and preserving wealth rather than taking risk to grow wealth

- "Worriers" obsess over short-term performance

- Slow to make investment decisions and are uncomfortable with change.

- Careful not to take excessive risks

- Gain wealth by risking other people capital

- May not be highly financial sophisticated

- Like consistency

- Focus on family and security issues

- Focus on the security picture and emotional issues as its better than detailed aspect of sharpe ratio and cognitive errors

- Driven by emotion

Loss Aversion Bias: Emotional

- Feel the pain of losses more than the pleasure of gains

- Hold on to losing investments too long

Status Quo Bias: Emotional

- Preference to keep their investments (and other parts of their life) the same

- Dont fix it if it ain't broke

Endowment Bias: Emotional

Value an investment that they already own more than an investment if they had not owned it

Anchoring Bias: Cognitive

Cling to purchase points and arbitrary price levels when facing questions like "should i buy or sell this investment

Mental Accounting Bias: Cognitive

Treat various sums of money differently based on where these sums are mentally categorized

advising passive preserver

- The big picture and not on excessive cognitive detail

- What money will accomplish. E.g. Family legacy goals, education

- Building trust by gaining commitment to the financial process

- Likely to become an advisers best clients because they value greatly the advisers professional expertise and objectivity in helping make the right investment decisions

Friendly Follower ; basic type and risk tolerance and primary bias

Basic Type: Passive

Risk Tolerance level: low to medium

Primary bias: cognitive

Friendly follower charcteristics

- Passive investors who follow the lead of their friends and colleagues in investment decisions

- Don't enjoy or have an aptitude for the investment process

- Latest most popular investments

- Overestimate there risk tolerance

Recency Bias: Cognitive

- Predisposition for investors to give recent events more importance than less recent events.

- Extrapolate patterns where none exist.

- Whatever happens now will continue on into the future

Hindsight Bias: Cognitive

- Investors believe that investment outcomes were predictable

- Leads to a false sense of security

- Take excessive risk without recognizing it, embeds them to take more successive risk

- lack of independent thought of investment

Framing bias: Cognitive

- Tendency of follower to respond to different situations differently based on the context in which a choice is presented (framed).

Cognitive Dissonance Bias: Cognitive

- Need to reduce discomfort when faced with conflicting belief position

- Followers reduce their discomfort by ignoring the truth and rationalizing their decisions.

Regret Aversion Bias: Emotional

- Avoid taking decisive actions because they fear making the wrong decisions

- Consequently, no decision is made

Advising Friendly Follower

- Advisors should challenge Follower clients to be introspective and provide

data-backed substantiation for recommendations.

- Provide a steady educational approach

Independent Individualist ; basic type and risk tolerance and primary bias

Basic Type: Active

Risk tolerance: Medium to high

Primary Bias: Cognitive

Independent Individualist Characteristics

- Actively involved in their wealth creation, typically risking their own wealth capital

- Higher tolerance for risk because they are very confident in themselves

- Very involved in investment decision process

- Self-assured and "trust their instincts"

- May be obsessed with beating the market and hold concentrated positions

- Prefer some kind of control with investment decisions

- Will do there own research

- May have a concentrated portfolio

- Strong willed independent thinker

Conservatism bias: Cognitive

Cling to a prior view or forecast without acknowledging new information

Availability bias: Cognitive

Easily recalled items are believed to have a higher probability of occurrence

Representative Bias: Cognitive

To make new information more easier to understand, investors project outcomes that resonate with their own pre-existing ideas

Self-Attribution Bias: Cognitive

Independant individualists take credit for their successes as innate talent, while blame failures to external factors

Confirmation Bias: Cognitive

Independent individualists over value and actively seek out information that confirms their claims and ignore information that discounts their beliefs

Advising Independent individualist

- Respect their independent views and educate on the benefits of portfolio

- diversification and sticking to a long-term plan.

- Advisors should provide data-backed substantiation for recommendations

Active Accumulator ; basic type and risk tolerance and primary bias

Basic Type: Active

Risk Tolerance Level: High

Primary basis: Emotional

characteristic of Active Accumulator

- Most aggressive behavioral investor types.

- First generation entrepreneurs risking their own capital

- Overconfident in their abilities and will often chase high return investments that others recommend.

- Want to control outcomes of investment activities and all spheres of their life

- May lack self control

OVerConfidence Bias: Emotional

Active accumulators have an unwarranted faith in their own thoughts and abilities.

Self-Control Bias: Emotional

Tendency to consume today at the expense of saving for tomorrow.

Affinity Bias: Emotional

- Tendency to make irrational, uneconomical choices based on how active accumulators believe a certain product or service will reflect their values.

- Ex. A person might buy a $200 bottle red wine instead of $20 as it is more prestigious and adds to their value they go to dinner with someone

llusion of Control Bias: Cognitive

Trading-oriented Active Accumulators believe that they can control investment outcomes when, in fact, they cannot.

Best

Outcome Bias: Cognitive

Active Accumulators make an investment (e.g. mutual fund) based on the outcome of the past five years rather than by observing the process by which the outcome came about

Advising Active Accumulators

- Active Accumulators are most difficult clients to advise

- Like to take control and exhibit overconfidence and optimism

- Lacks self-control and may overspend

- Advisors should take control through the investment process

Limitations to investors for classification

- Individuals may exhibit both cognitive errors and emotional biases.

- Individuals may exhibit characteristics of multiple investor types.

- Individuals will likely go through behavioral changes as they age.

- Individuals are likely to require unique treatment even if they are classified as the same investor type because human behavior is so complex.

- Individuals act irrationally at different times and without predictability.

How Behavioral Factors Affect Adviser-Clientrelations

1. The adviser understands the client's financial goals and characteristics. These are considered when developing the investment policy statement.

2. The adviser maintains a systematic (consistent) approach to advising the client.

3. The adviser invests as the client expects. Results are communicated on a regular basis and in an effective manner that takes into account the client's characteristics.

4. The relationship benefits both client and adviser.

Limitations of Traditional Risk Tolerance Questionnaires

- Does not take into consideration actual observed behavior (Behavioral biases)

- How the risk tolerance questions are framed and asked will elicit a specific response

- Risk tolerance needs to be reviewed regularly at least once a year along with IPS

- Practitioners should not take the risk tolerance too literally

- Risk tolerance questionnaire can produce dramatically different results when administered repeatedly with the same individual

3.1 Formulating Financial Goals

- Understand the psychology and emotions involved in the decisions underlying the goals

- Insight equip the adviser to deepen the bond with the client, thus producing a better relationship and a better investment outcome

3.2 Maintaining a Consistent Approach

- Incorporate behavioral finance can become part of that discipline without requiring large-scale changes in the advisers method

- Add professionalism and structure to the relationship

- Better understand the client before delivering any investment advice

3.3 Investing as the Client Expects

- Addressing client expectations is essential to a successful relationship

3.4 Ensuring Mutual Benefits

- Measures resulting in happier more satisfied clients will also improve the adviser's practice and work life

- Develop stronger bond between client and advisor