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