Contributions P OMPIAN

Using Behavioral Investor Types to Build Better Relationships with Your Clients

by Michael M. Pompian, CFP ®, CFA

Michael M. Pompian, CFP®, CFA, is the director of the Private Wealth Practice and a principal consultant at Executive Summary Hammond Associates, a St. Louis, Missouri-based invest - ment consulting firm with over $55 billion in assets under advisement. He can be reached at (314) 746-1600 or at • Since the bursting of the technology • A description of each behavioral [email protected]. stock bubble in 2000, behavioral investor type is provided with exam - finance has taken a more prominent ples of the cognitive and emotional role in the financial media and, more biases associated with each BIT. Advice ehavioral finance, which identifies importantly, in the minds of financial is given on how best to work with and learns from the human psy - advisors globally. each behavioral investor type so that Bchological phenomena at work in • This paper is a continuation and refine - the advisor can build stronger client financial markets and within individual ment of a March 2005 Journal of Finan - relationships. investors, has taken a more prominent cial Planning article, “Incorporating • The paper then presents a diagnostic place in the financial advisory world since Behavioral Finance into Your Practice.” It process called Behavioral Alpha™, a the bursting of the technology stock bubble presents a framework for financial advi - top-down methodology of classifying in March 2000. Evidence of this fact is sors to categorize their clients into four client investors into behavioral investor documented in my August 2007 research behavioral investor types , or BITs . BITs types based on their behavioral char - study titled “The Ultimate Know-Your-Cus - were designed for advisors to help them acteristics. tomer Approach: Using Behavioral Finance more easily apply behavioral finance to • The Behavioral Alpha approach begins 1 to Retain and Acquire Wealth Clients.” In the everyday task of advising clients. by identifying investors as either active that study, I surveyed 290 sophisticated • The four behavioral investor types are or passive . The next step is to administer financial advisors (identified as such by Passive Preserver, Friendly Follower, a risk-tolerance questionnaire. After that, having at least one advanced designation, Independent Individualist, and Active behavioral biases are isolated to deter - such as CFP®, CFA, or CPA) in 30 coun - Accumulator. mine a client’s behavioral investor type. tries about their interest in and use of behavioral finance with their clients. The results were astounding: 93 percent of par investment results. Advisors acknowl - lessly struggling with behavioral finance advisors believed that individual investors edge that the most common reason they because they lack a systematic way to apply make irrational investment decisions, and lose clients is that they are unable to get it to their client relationships. This paper 96 percent were successfully using behav - inside the heads of their clients enough to intends to make the application of behav - ioral finance to improve relationships with build solid personal and financial relation - ioral finance easier by building on key con - their clients. ships. Understanding how clients actually cepts outlined in my earlier March 2005 Why is behavioral finance catching on? think and behave is a key ingredient in the Journal of Financial Planning article, “Incor - These advisors have figured out that recipe for success in acquiring and retain - porating Behavioral Finance into Your acquiring clients is difficult and expensive, ing clients. As such, behavioral finance is Practice,” 2 and my 2006 book, Behavioral and losing them is easy—and contrary to becoming a powerful force in the financial Finance and Wealth Management. 3 In those popular belief, the primary reason financial advisory field. two works, I outline a method of applying advisors lose clients is not because of sub- But some financial advisors are need - behavioral finance to private clients in a

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way that I now refer to as “bottom-up.” for some of the behavioral biases and making investment recommendations will This means that for an advisor to diagnose advice for dealing with each BIT. The be much better prepared to deal with irra - and treat behavioral biases, he or she must paper concludes with a review of the tional behavior when it arises. first test for all behavioral biases in the Behavioral Alpha approach to identifying client, and then determine which ones a BITs, which starts by identifying active and Passive Preserver client has before being able to use bias passive investor traits and then uses tradi - information to create a customized invest - tional risk tolerance questionnaires to ini - Basic type: Passive ment plan. For example, in my book I tially classify the client before identifying Risk tolerance level: Low describe 20 of the most common behav - the client’s irrational biases to determine Primary bias: Emotional ioral biases an advisor is likely to the client’s BIT. Passive Preservers are, as the name encounter, explain how to diagnose these implies, investors who place a great deal of biases, show how to identify behavioral Introduction to Behavioral Investor Types emphasis on financial security and preserv - investor types, and finally show how to plot ing wealth rather than taking risks to grow this information on a chart to create the Behavioral investor types were designed to wealth. Many have gained wealth through “best practical allocation” for the client. help advisors make rapid yet insightful inheritance or conservatively by working in But some advisors may find this bottom-up assessments of what type of investor they a large company. Because they have gained approach too time-consuming or complex. are dealing with before recommending an wealth by not risking their own capital, So in this paper, I present a simpler, more investment plan. The benefit of defining Passive Preservers may not be financially efficient approach to bias identification what type of investor an advisor is dealing sophisticated. Some Passive Preservers are that is “top-down”—a shortcut, if you with up front is that this will mitigate “worriers” in that they obsess over short- will—that can make bias identification unwelcome surprises from the client wish - term performance and are slow to make much easier. I call it Behavioral Alpha™. ing to change the portfolio allocation due investment decisions because they dislike The Behavioral Alpha approach is a to market turmoil. If an advisor can reduce change. This is consistent with the way multi-step diagnostic process that classifies traumatic episodes throughout the advisory they have approached their professional clients into four behavioral investor types process by delivering smoother, anticipated lives, being careful not to take excessive (BITs). Bias identification, which is done investment results due to an investment risks. Some Passive Preservers who inherit near the end of the process, is narrowed plan that is customized to the client’s wealth may have intense feelings of guilt or down for the advisor by giving the advisor behavioral make-up, the client relationship low self-esteem because they didn’t earn clues as to which biases a client is likely to will be stronger. BITs, are not intended to their money, and may have a fear of failure have based on the client’s BIT. be absolutes, but rather guideposts to use or lack of motivation. The word “alpha” is used for two rea - when making the journey with a client; Most Passive Preservers are focused on sons. For one thing, it means “first” or “the dealing with irrational investor behavior is taking care of their family members and beginning.” Before an investment program not an exact science. For example, an advi - future generations, especially funding life- is created for a client, financial advisors sor may find that he or she has correctly enhancing experiences such as education need to take inventory of a client’s behav - classified a client as a certain BIT, but finds and home buying. Because the focus is on ior first —hence Behavioral Alpha. Second, that the client also has traits (biases) of family and security, Passive Preserver the word has become synonymous with another. biases tend to be emotional rather than describing performance beyond expecta - Each BIT is characterized by a certain cognitive. As age and wealth level increase, tions. By taking inventory of a client’s risk tolerance level and a primary type of this BIT becomes more common. Although investing behavior before creating an bias—either cognitive (driven by faulty rea - not always the case, many Passive Pre - investment plan, the result will likely be soning) or emotional (driven by impulses servers enjoy the wealth management performance that exceeds both the expec - or feelings). One of the most important process—they like the idea of being tations of the client and the advisor. concepts advisors should keep in mind as catered to because of their financial The paper begins with an introduction to they go through this section is that the status—and thus are generally good clients. the four behavioral investor types: least risk-tolerant BIT and the most risk- Behavioral biases of Passive Preservers 1. Passive Preservers tolerant BIT are driven by emotional biases, tend to be emotional, security-oriented 2. Friendly Followers while the two types in between these two biases such as endowment bias, loss aver - 3. Independent Individualists extremes are mainly affected by cognitive sion, status quo, and regret. They also 4. Active Accumulators biases. Emotional clients tend to be more exhibit cognitive biases such as anchoring Next, a detailed description of each BIT difficult clients to work with. Advisors who and mental accounting. is provided, including a simple diagnostic can recognize the type of client before Endowment bias. This emotional bias

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occurs when a person assigns greater value changes, only to find that the investor money, money for retirement, and vacation to an object when he or she possesses it takes part of or none of the advice. It’s not money. If all of these assets are viewed as and is faced with its loss, than when he or that the client doesn’t need good advice— “safe money” sub-optimal returns are usu - she doesn’t possess the object and has the they are simply stuck in the status quo. ally the result. potential to gain it. A classic example of Regret aversion bias. People exhibiting Advising passive preservers. After endowment bias is a client who holds onto this emotional bias avoid taking decisive reviewing this section, readers might cor - investments that were owned by previous actions because they fear that, in hind - rectly conclude that Passive Preservers are generations, particularly concentrated sight, whatever course they select will difficult to advise because they are driven equity positions or real estate that may prove less than optimal. Regret aversion mainly by emotion. This is true; however, have created the family’s wealth to begin can cause investors to be too conservative they are also greatly in need of good finan - with, without justification for why these in their investment choices. Having suf - cial advice. Advisors should take the time assets are retained. fered losses in the past, they may shy away to interpret behavioral signs provided to Ask your client if they keep objects or from making sensible new investments. them by Passive Preserver clients. Passive investments because they already own This behavior can lead to long-term under - Preservers need “big picture” advice and them (through inheritance, for example), performance and can jeopardize invest - advisors shouldn’t dwell on details like but wouldn’t be interested in buying these ment goals. standard deviations and Sharpe ratios, or objects or investments themselves. If so, Ask your client if they have made invest - else they will lose the client’s attention. they are likely to have endowment bias. ments in the past that they regret—and if Passive Preservers need to buy into their Loss aversion bias. Most Passive Pre - that regret affects current or future invest - advisor’s general philosophy first and then, servers feel the pain of losses more than ment decisions. once trust is gained, they will take action. the pleasure of gains—the essence of loss Anchoring bias. This cognitive bias After a period of time, Passive Preservers aversion. This emotional bias prevents occurs when investors are influenced by are likely to become an advisor’s best people from unloading unprofitable invest - purchase points or arbitrary price levels, clients because they value greatly the advi - ments, even when they see no prospect of and tend to cling to these numbers when sor’s professional expertise and objectivity a turnaround. Some industry veterans have facing questions like “should I buy or sell in helping make the right investment deci - coined this “get-even-itis.” Holding losing this investment?” sions. investments in the hope that they get back One of the most common examples of to break-even has seriously negative conse - anchoring bias occurs during the imple - Friendly Follower quences on portfolio returns when these mentation of a new asset allocation. For investments stay in losing territory for example, suppose a client comes to an Basic type: Passive extended periods. advisor with 30 percent of their portfolio Risk tolerance level: Low to medium A simple diagnostic for loss aversion in a single stock and the advisor recom - Primary bias: Cognitive bias: Provide your client a scenario in mends diversification. Further suppose Friendly Followers are passive investors which they buy a security and it drops 25 that the stock is down 25 percent from the who usually do not have their own ideas percent with no foreseeable rebound. Ask high it reached five months ago ($75 a about investing. They often follow the lead if they are likely to hold it until it gets back share versus $100 a share). For simplicity, of their friends and colleagues in invest - to even or sell it and buy something with assume that taxes on the sale are not an ment decisions, and want to be in the better prospects. If they hold on to the issue. Frequently, the client will resist the latest, most popular investments without investment, they are likely to have loss new allocation because they feel they must regard to a long-term plan. One of the key aversion bias. only sell the stock when its price rebounds challenges of working with Friendly Fol - Status quo bias. This emotional bias to the $100 a share it achieved five months lowers is that they often overestimate their predisposes people, when facing an array of ago. This is anchoring bias. risk tolerance. Advisors need to be careful choices, to elect whatever option keeps Mental accounting bias. The last Pas - not to suggest too many “hot” investment conditions the same. Passive Preservers sive Preserver bias is mental accounting, a ideas—Friendly Followers will likely want often tell themselves “things have always cognitive bias that occurs when people to do all of them. Some don’t like, or even been this way” and are more comfortable treat various sums of money differently fear, the task of investing, and many put off keeping things the same. Status quo bias is based on where these sums are mentally making investment decisions without pro - demonstrated by the investor who has been categorized. Passive Preservers are risk fessional advice; the result is that they doing things a certain way for many years, averse and like to segregate their assets maintain, often by default, high cash bal - and then hires a new financial advisor. The into safe “buckets.” A classic example of ances. Friendly Followers generally comply new advisor may propose practical mental accounting is segregating college with professional advice when they get it,

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and they educate themselves financially, a risk-taking response is more likely. When Friendly Followers often overestimate their but can at times be difficult because they questions are worded in the loss “frame,” risk tolerance. Risky trend-following behav - don’t enjoy or have an aptitude for the then risk-averse behavior is the likely ior occurs in part because Friendly Follow - investment process. Biases of Friendly Fol - response. ers don’t like situations of ambiguity. They lowers are cognitive: recency, hindsight, A simple diagnostic for framing bias is to also may convince themselves that they framing, cognitive dissonance, and ambigu - pick one question from a typical risk toler - “knew it all along,” which also increases ity aversion. ance questionnaire and re-phrase it to test risk-taking behavior. Advisors need to Recency bias. This is a predisposition if a client would answer the same question handle Friendly Followers with care for people to more prominently recall and differently based on how it is asked. If they because they are likely to say yes to advice emphasize recent events or observations, answer the question differently, they are that makes sense to them. Advisors need to and potentially extrapolate patterns where likely subject to framing bias. guide them to take a hard look at behav - none exist. Recency bias ran rampant Cognitive dissonance bias. In psychol - ioral tendencies to overestimate their risk during the bull market period between ogy, cognitions represent attitudes, emo - tolerance. Because Friendly Follower biases 1995 and 1999 when many investors tions, beliefs, or values. When multiple are mainly cognitive, education on the ben - wrongly presumed that the market would cognitions intersect—for example, a situa - efits of portfolio diversification is usually continue its enormous gains forever. tion arises in which a person believes in the best course of action. Advisors should Friendly Followers often enter an asset something only to find out it is not true— challenge Friendly Follower clients to be class when prices are peaking, which can they try to alleviate their discomfort by introspective and provide data-backed sub - end badly with sharp price declines. ignoring the truth and rationalizing their stantiation for recommendations. Offer Hindsight bias. Friendly Followers, who decision to ignore the truth. Friendly Fol - education in clear, unambiguous ways so often lack independent thought on invest - lowers who suffer from this bias may con - they have the chance to get it. If advisors ments, are susceptible to hindsight bias, tinue to invest in a security or fund they take the time, this steady, educational which occurs when an investor perceives already own after it has gone down (aver - approach will generate greater client loy - investment outcomes as if they were pre - age down), even when they know they alty and adherence to long-term invest - dictable—even if they weren’t. An example should be judging the new investment with ment plans. of hindsight bias is the response by objectivity. A common phrase for this con - investors to the tech stock bubble when, cept is “throwing good money after bad.” Independent Individualist initially, many viewed the market’s per - Ambiguity aversion bias. This is a diffi - formance as normal (not symptomatic of a cult bias to explain; therefore, an example Basic type: Active bubble), only to later say, “Wasn’t it obvi - works best. Suppose a researcher asks Mr. Risk tolerance: Medium to high ous?!” when the market melted. (Ask your Jones (or you ask your client) his predic - Primary bias: Cognitive client if they thought the bursting of the tion of the outcome of an ambiguous situa - An Independent Individualist is an active 2000 technology stock bubble was pre - tion: whether a certain sports team will investor with medium-to-high risk toler - dictable.) The result of hindsight bias is win its upcoming game. Suppose he esti - ance who is strong-willed and an inde - that it gives investors a false sense of secu - mates a 60 percent chance the team wins. pendent thinker. Independent Individual - rity when making investment decisions, Further suppose the researcher presents ists are self-assured and “trust their gut” and thus excessive risk is taken. Mr. Jones with a 50 percent/50 percent when making decisions; however, when Framing bias. This is the tendency of slot machine, which offers no ambiguity, they do research on their own, they may be Friendly Followers to respond differently to and then asks which bet is preferable. If susceptible to acting on the initial informa - various situations based on the context in Mr. Jones is ambiguity-averse, he will likely tion rather than getting corroboration from which a choice is presented (framed). choose the slot machine, even if he feels other sources. Sometimes advisors find Investors often focus too restrictively on confident about the team winning. Trans - that an Independent Individualist client one or two aspects of a situation, excluding lating this idea to the investment world, made an investment without consulting other considerations. The use of risk toler - even when investors feel skillful or knowl - anyone. This can be problematic because, ance questionnaires provides a good exam - edgeable, they may not be willing to stake due to their independent mindset, these ple. Depending on how questions are claims on “ambiguous” investments like clients maintain the view they had when asked, framing bias can cause investors to stocks, even when they believe they can they made the investment, even when respond to risk tolerance questions in predict these outcomes based on their own market conditions change. They often either an unduly conservative or risk- judgment. enjoy investing and are comfortable taking taking manner. For example, when ques - Advising Friendly Followers. Advisors risks, yet often resist following a financial tions are worded in the gain “frame,” then to Friendly Follower clients know that plan.

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the probability of an outcome based on bias can cause investors to only seek infor - Recommended Web Sites how prevalent that outcome is in their mation that confirms their beliefs about an lives. People exhibiting this bias perceive investment and not seek out information • Behavioral Alpha: easily recalled possibilities as more likely that may contradict their beliefs. This http://www.behavioralalpha.com than those that are less prevalent. Ask your behavior can leave investors in the dark • Daniel Kahneman biography— client to identify the “best” mutual funds. regarding the imminent decline of a stock. Woodrow Wilson School of Public Most Independent Individualists would Advising Independent Individualists. and International Affairs: perform an Internet search and, most Independent Individualists can be difficult http://www.princeton.edu/~kahne likely, find funds from firms that engage in clients to advise, but they are usually man/ heavy advertising. Investors subject to grounded enough to listen to sound advice • Numerour research papers: availability bias are influenced to pick when it is presented in a way that respects http://faculty.haas.berkeley.edu/ode funds from such companies, despite the their independent mindset. As we have an/Current%20Research.htm fact that some of the best-performing learned, Independent Individualists are • Meir Statman biography—Santa funds advertise very little if at all. firm in their belief in themselves and their Clara University: Representativeness bias. This occurs as decisions, but can be blind to contrary http://www.scu.edu/business/financ a result of a flawed perceptual framework thinking. As with Friendly Followers, edu - e/faculty/statman.cfm when processing new information. To cation is essential to changing behavior of • Institute of Behavioral Finance: make new information easier to process, Independent Individualists; their biases are http://www.ibfsa.co.za/ Independent Individualists project out - predominantly cognitive. A good approach comes that resonate with their own pre- is to have regular educational discussions existing ideas. An Independent Individual - during client meetings. This way, the advi - Some Independent Individualists view ist might view a particular stock, for sor does not point out unique or recent investing as a way to make money to give example, as a value stock because it resem - failures, but rather educates regularly and themselves freedom. They can be good bles an earlier value stock that was a suc - can incorporate concepts that he or she clients because they are usually busy cessful investment—but the new invest - feels are appropriate for the client. people, although some will not accept ment is actually not a value stock. For financial advice. Others are obsessed with example, a high-flying biotech stock with Active Accumulator trying to beat the market and may hold scant earnings or assets drops 25 percent concentrated portfolios. Of all behavioral after a negative product announcement. Basic type: Active investor types, Independent Individualists Some Independent Individualists may take Risk tolerance: High are the most likely to be contrarian, which this to be representative of a value stock Primary bias: Emotional and cognitive can benefit them—and lead them to con - because it is cheap; but biotech stocks The Active Accumulator is the most tinue their contrarian practices. Independ - don’t typically have earnings, while tradi - aggressive behavioral investor type. These ent Individualist biases are cognitive: con - tional value stocks have had earnings in clients are entrepreneurial and often the servatism, availability, confirmation, the past but are temporarily underperform - first generation to create wealth, and they representativeness, and self-attribution. ing. are even more strong-willed and confident Conservatism bias. This occurs when Self-attribution bias. This refers to the than Independent Individualists. At high people cling to a prior view or forecast tendency to ascribe successes to innate tal - wealth levels, Active Accumulators often without acknowledging new information. ents while blaming failures on outside have controlled the outcomes of non- Independent Individualists often do this, influences. For example, suppose an Inde - investment activities and believe they can behaving inflexibly when presented with pendent Individualist makes an investment do the same with investing. This behavior new information. For example, assume an that goes up. The reason it went up is not can lead to overconfidence in investing investor buys a security based on an antici - due to random factors such as economic activities. Left unadvised, Active Accumu - pated new product announcement. The conditions or competitor failures, but lators often have high portfolio turnover company then announces that it is experi - rather to the investor’s investment savvy. rates, putting a drag on investment per - encing problems bringing the product to This is classic self-attribution bias. formance. Active Accumulators seek risk in market. The investor may cling to the stock Confirmation bias. This occurs when the hope of high return and are comfort - with the optimistic opinion that the prob - people observe, overvalue, or actively seek able with volatility, although they don’t like lems will soon be resolved, and fail to sell out information that confirms their claims, it. Active Accumulators are quick decision- on the negative announcement. while ignoring or devaluing evidence that makers but may chase higher risk invest - Availability bias. People often estimate might discount their claims. Confirmation ments than their friends. If successful, they

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to constantly adjust it. For example, trad - Tests for Active and Passive Investing Traits ing-oriented investors who accept high levels of risk believe themselves to possess 1. Have you earned the majority of b. 40 percent stocks/60 percent more control over the outcome of their your wealth in your lifetime? bonds investments than they actually do because a. Yes 7. Is your wealth goal intended to they are pulling the trigger on each deci - b. No continue your current lifestyle or sion. 2. Have you risked your own capital in are you motivated to build wealth To determine whether your client has the creation of your wealth? at the expense of current lifestyle? control bias, ask if they have a tendency to a. Yes a. Build wealth want to pick their own numbers on a lot - b. No b. Continue current lifestyle tery ticket or want to be in control of the 3. Which is stronger: your tolerance 8. In your work or personal life, are dice while playing a game of chance. for risk to build wealth or the you generally a self-starter in that Self-control bias. This emotional bias is desire to preserve wealth? you seek to out what needs to be the tendency to consume today without a. Tolerance for risk to build done and then do it, or do you saving for tomorrow. The primary concern wealth prefer to take direction from some - for advisors with this bias is a client with a b. Desire to preserve wealth one else? high risk tolerance coupled with high 4. Would you prefer to maintain a a. Self-starter spending. For example, suppose you have degree of control over your invest - b. Take direction an Active Accumulator client who prefers ments or to delegate that responsi - 9. Are you “income motivated” or are aggressive investments and has high cur - bility to someone else? you willing to put your capital at rent spending needs and suddenly the a. Maintain control risk to build wealth? financial markets hit some severe turbu - b. Delegate a. Put capital at risk lence. Just to meet expenses, this client 5. Do you have faith in your abilities b. Income motivated may be forced to sell solid long-term as an investor? 10. Do you believe in the concept of investments that have declined in value a. Yes leverage or do you prefer to limit due to current market conditions. b. No your amount of debt? Optimism bias. Many overly optimistic 6. If you had to pick one of two port - a. Believe in leverage investors believe that bad investments will folios, which would it be? b. Limit debt not happen to them—they will only afflict a. 80 percent stocks/20 percent others. Such an illusion can damage portfo - bonds lios as people fail to acknowledge the potential for adverse consequences in the investment decisions they make. An exam - enjoy the thrill of making a good invest - their judgment. Many Active Accumulators ple of this emotional bias occurs when ment. Some Active Accumulators can be claim an above-average aptitude for select - employees allocate a high proportion of difficult to advise because they don’t usu - ing stocks; however, numerous studies their 401(k) plan to their company’s stock. ally believe in basic investment principles have shown this to be a fallacy. For exam - Undue optimism leads these employees to such as diversification and asset allocation. ple, a study done by researchers Odean and perceive their own firm as being unlikely They are often hands-on, wanting to be Barber 4 showed that after trading costs to suffer from economic misfortune. heavily involved in the investment deci - (but before taxes), the average investor Advice for active accumulators. Active sion-making process, although some read - underperformed the market by approxi - Accumulators are the most difficult clients ily admit they lack investment knowledge. mately 2 percent a year due to unwar - to advise. They like to control, or at least Biases of Active Accumulators are overcon - ranted belief in their ability to assess the get deeply involved in, the details of invest - fidence, self-control, optimism, and illu - correct value of investment securities. ment decision-making. They are emotion - sion of control. Illusion of control bias. This cognitive ally charged and optimistic that their Overconfidence bias. This is best bias occurs when people believe they can investments will do well, even if that opti - described as unwarranted faith in one’s control, or at least influence, investment mism is irrational. Some Active Accumula - own thoughts and abilities and contains outcomes when, in fact, they cannot. tors need to be monitored for excess both cognitive and emotional elements. Active Accumulators who are subject to spending which, when out of control, can Overconfidence manifests itself in illusion of control bias believe that the best inhibit performance of a long-term portfo - investors’ overestimation of the quality of way to manage an investment portfolio is lio. The best approach to dealing with

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these clients is to take control of the situa - tion. If advisors let the Active Accumulator 4WUc`S ( 7ZZcab`ObW]\ ]T @WaY BV`SaV]ZR 0OaSR ]\ @WaY1/B>`]TWZS client dictate the terms of the advisory AQ]`S engagement, they will always be at the mercy of the client’s irrational decision- 5S\S`OZ Bg^S >/AA7D3 /1B7D3 making and the result will likely be an <======||======> unhappy client and an unhappy advisor. @WaY B]ZS`O\QS :]e ;SRWc[ 6WUV Advisors need to prove to the client that they have the ability to make wise, objec - tive, long-term decisions and can commu - process. Recall that we use the term should also ascertain whether a client is an nicate these results in an effective way. “alpha” because we are categorizing our active or passive investor. In short, has the Advisors who can demonstrate the ability clients by investor type before we embark client in the past (or does the client now) to take control of a situation will see their on the design of an investment program. wish to put his or her capital at risk to Active Accumulator clients fall into step We start first with a diagnosis of passive or build wealth? 5 Understanding the charac - and be easier to advise. active traits. teristics of active and passive investors is Step 1: Interview client and identify important because passive investors have The Behavioral Alpha Process: A Top-Down active or passive traits. Most advisors tendencies toward certain investor biases, Approach begin the planning process with a client and active investors have tendencies interview, which consists mainly of a ques - toward different biases. The sidebar “Test Now that we have learned each behavioral tion-and-answer session intended to gain for Active and Passive Investing Traits” pro - investor type in detail, we will examine the an understanding of the objectives, con - vides questions to determine the active or diagnostic process for arriving at an indi - straints, and past investing practices of a passive nature of clients. A preponderance vidual BIT using the Behavioral Alpha client. Through this process an advisor of “A” answers indicates an active investor

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www.FPAjournal.org O CTOBER 2008 | Journal of Financial Planning 69 Contributions P OMPIAN

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and “B” answers identify passive investors. ated with the expected BIT (as we learned adjust their advice accordingly. Step 2: Administer risk tolerance earlier in the paper). This will confirm the JFP questionnaire. Once the advisor has classi - BIT diagnosis. Figure 3 provides an fied the investor as active or passive, the overview of the characteristics of each Endnotes next step is to administer a traditional risk behavioral investor type. tolerance questionnaire to begin the 1. Michael M. Pompian, “The Ultimate process of identifying whether a client falls Conclusion Know-Your-Customer Approach: Using into one of the four behavioral investor Behavioral Finance to Retain and types. In the interest of keeping this article We have learned a top-down method of Acquire Wealth Clients,” VRL Knowl - to a reasonable length, I have not included identifying a client’s behavioral investor edgeBank, London, England, 2007: a risk tolerance questionnaire. The advi - type. By learning this process and applying 73–83. sor’s task at this point is to determine it before creating an investment plan for a 2. Michael M. Pompian and John M. where the client falls on the risk scale. This client, the client is more likely to be able to Longo, “Incorporating Behavioral is shown in Figure 1. adhere to a plan that is custom designed Finance Into Your Practice,” Journal of The next step is to confirm the expecta - for them and, when this happens, financial Financial Planning 18, 3: 58–63. tion that certain behavioral traits will advisors build stronger relationships with 3. Michael M. Pompian, Behavioral result in certain behavioral investor types. their clients. The ultimate objective for this Finance and Wealth Management, New If an investor is passive, and the risk toler - process is for advisors to get comfortable Jersey: John Wiley and Sons, 2006. ance questionnaire reveals a very low risk enough with the BIT process such that it 4. Terrence Odean and Brad Barber, “Boys tolerance, the investor is likely to be a Pas - becomes natural, almost second nature, Will Be Boys: Gender, Overconfidence, sive Preserver. If the investor is passive and and can be incorporated easily and effi - and Common Stock Investment,” Quar - the questionnaire reveals a low to medium ciently into the advisory process. As a final terly Journal of Economics 116, 1 (Febru - risk tolerance, the investor is likely to be a note, advisors should realize that clients ary 2001): 261–292. Friendly Follower. If an investor is active will have stronger or weaker forms of the 5. It is important to make a distinction and has a medium to high risk tolerance, behavioral investor types presented here between investing in a diversified port - the investor is likely to be an Independent based on the number and severity of the folio and risking capital. Risking capital Individualist. Finally, if an investor is active biases that are associated with each behav - involves doing things like building com - and has a high risk tolerance, the investor ioral investor type. Some clients will have a panies (big or small), investing in spec - is likely to be an Active Accumulator. This reasonably rational approach to investing, ulative real estate using leverage, or process is illustrated in the decision tree displaying few biases and which have little working for oneself rather than for a shown in Figure 2. impact on the investment process. Other large company. If, after going through this process, the clients will be highly biased and their irra - advisor has narrowed the client down to tional behavior will affect the investment one behavioral investor type, the next task process substantially. Advisors need to use is to confirm this BIT expectation by deter - their best judgment when assessing the mining if the client has the biases associ - potency of a client’s irrational behavior and

70 Journal of Financial Planning | O CTOBER 2008 www.FPAjournal.org