Our personalities play a role in nearly every aspect of our daily lives whether it’s influencing the type of car we drive, the hobbies we enjoy, or the qualities we seek from our personal relationships.
It may not come as much of a surprise then that our personalities can also play an important role in investing.
The good news for investors is that providing your wealth manager with an honest evaluation of your attitudes towards risk and decision making, it can allow them to incorporate that information as part of the investment management process.
Through the creation of an Investment Policy Statement (IPS) that gives careful attention to an individual’s unique circumstances including attitudes towards risk, both client and manager will be better equipped to navigate the journey towards achieving the client’s desired investment goals.
An introduction to the role of behavioural finance
Behavioural finance has emerged in recent years as a valuable complement to traditional finance theory.
While traditional finance theory has tended to focus on a more scientific approach to decision-making and the assumption that individuals act in a rational way in order to arrive at the optimal investment outcome, behavioural finance relaxes some of these assumptions.
Instead of trying to explain how individuals should act in theory, behavioural finance attempts to describe and predict how individuals actually do act in a given situation.
One of the most practical contributions that behavioral finance has given to the investment management industry thus far is an insight into how our personality types can affect our attitudes towards risk and decision-making.
Through a personal interview or short questionnaire, advisors will attempt to assign their client to a “personality type” that can help them to better understand the behavioural drivers that influence the client’s goal setting, asset allocation and risk-taking decisions.
This information can then be factored in when developing the client’s IPS, helping to establish the guidelines and processes that will govern the client-manager relationship.
Doing so will help the advisor to better manage the client’s expectations and behaviour.
Understanding the different investor personality types
Below are descriptions of a few of the more common investor personality types, as well as an explanation of how an IPS may be used to address the unique circumstances that each can present.
As the name suggests, methodical investors tend to follow a more conservative investment philosophy, one employing a well-thought out, strategic approach to decision-making and one that tends to rely on the observable “hard facts.”
These types of investors don’t often become emotional about money or their investments and will favour an established process, particularly one that incorporates rigorous analysis and research.
Methodical investors will gain comfort in following an IPS that outlines which types of investments are and aren’t permitted for inclusion as part of their portfolio and one that additionally sets out in advance a mutually-agreed-upon benchmark that can be used to evaluate the portfolio manager’s performance.
Cautious investors have typically been characterized as having a below-average risk tolerance compared to other investors with similar circumstances.
Sometimes this is because they’ve either accumulated their wealth through the receipt of gifts, an inheritance or by earning high compensation via employment.
Because none of the aforementioned circumstances has required them to put their own capital at risk, these clients may have less awareness or knowledge with regards to the nature of the relationship between risk and return present in capital markets.
However, for these types of investors, holding an overly skeptical view towards risk can sometimes lead to missing out on profitable investment opportunities.
In this respect, an IPS can prove valuable for the client in that it clearly outlines the degree of risk that the investor is and isn’t comfortable with, in advance.
By clearly establishing these expectations at the outset of the client-manager relationship, the client can rest assured knowing their wealth manager will be governed by the IPS and required to stay within the bounds of previously agreed limits.
At the same time, a carefully crafted IPS can also be beneficial to the wealth manager as an aid that can be used to help them to coach a client through a difficult market environment, reminding him or her that risk is a necessary element of investing and that the client has at the outset agreed to accept some degree of volatility in their portfolio.
Individualist investors are usually a confident bunch in that they aren’t averse to expressing their own opinions when it comes to making investment decisions.
Sometimes these individualists will reach their own independently held or “contrarian” conclusions with regards to a particular investment based on a piece of third-party research, an article they’ve read in the newspaper or something they’ve seen on television or online.
If the client indicates that he or she wants to have a say in the investment management process, an IPS can prove valuable in establishing at the outset how the client and manager intend to work together in arriving at their decisions.
Having a clear understanding at the outset as to the process that’s going to be followed along with the expectations held on both sides can help to go a long way in resolving any disputes, particularly if things don’t end up going exactly as planned.
Spontaneous investors have in some cases in the past posed a challenge for certain wealth managers because of their over-active nature.
That’s partly because spontaneous investors tend to be more emotional on average, and as a result tend to frequently update their outlook for the market as well as their various investment holdings in response to the latest news story or market development.
One of the issues this behaviour can present for advisors is that their client’s reactionary nature tends to result in them over-managing the account, often leading to higher fees and commissions, excessive account turnover and below-average returns.
An IPS can prove useful for both the client and the advisor in these cases by establishing at the outset the level of control the client is handing over to the manager.
Additionally, the creation of an IPS can also provide the advisor with a valuable opportunity to educate his or her client about the explicit and implicit costs involved with excessive trading activity.
Not only can an evaluation of the client’s personality type be useful in helping the wealth manager to develop a specific and meaningful IPS, but it can also be valuable in providing the client with a greater sense of awareness regarding their own views towards risk and decision-making.
The result of which should be better two-way communication between client and manager and more honest, informed and open conversations around the topic of risk.