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 in personal relationships. It may not come as much of a surprise that our personalities can also play an important role in investing.
For investors, providing your wealth manager with an honest evaluation of your attitudes towards risk and decision-making can allow them to incorporate that information into the investment management process.
Through the creation of an Investment Policy Statement (IPS), both the client and manager better navigate the journey towards achieving the client’s desired investment goals. Continue reading to learn more about an IPS and personality types in relation to investing.
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Assess your personality type
Before you can assess your relationship with investing risks and decision making, you’ll need to look inward. Each person is unique in their own way, but there are definitely trends in personality types. Below are some personality tests you can do for free:
- 16Personalities. The philosophy behind 16Personalities is there are 4 broad categories: Analysts, Diplomats, Sentinels, and Explorers. These 4 categories have 4 sub-personalities, which composes the 16 personality types. 16Personalities is often used in workplaces to guage how different people work and succeed. Use it to understand who you are as an investor too.
- DiSC. DiSC stands for Dominant, Inspiring, Supportive and Conscientious. The test works by categorizing you into one of the categories. Then assess you at a certain degree of that category.
- High5 Test. This test focuses on your strengths as a unique individual. As opposed to grouping you into a category of similar traits. The High5 Test can help you identify your strengths, and areas for improvement.
By better understanding your personality, you can communicate your goals and attitudes more effectively with a wealth manager.
An introduction to the role of behavioural finance
Behavioural finance has emerged in recent years as a valuable complement to traditional finance theory.
Traditional finance theory tends to focus on a more scientific approach to decision-making. The assumption is that individuals act in a rational way to arrive at the optimal investment outcome. Behavioural finance relaxes some of these assumptions. Instead of trying to explain how individuals should act, behavioural finance attempts to describe and predict how individuals actually act.
One of the most practical contributions of behavioral finance in the investment management industry is 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”. This can help to better understand the behavioural drivers that influence the client’s goal setting, asset allocation, and risk-taking decisions. Consider this information when developing the client’s IPS. Then helps 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 the more common investor personality types. In addition, an explanation of how an IPS can address the unique circumstances each can present.
As the name suggests, methodical investors tend to follow a conservative investment philosophy. They employ 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. They will favour an established process, particularly one that incorporates rigorous analysis and research.
Methodical investors will gain comfort in following an IPS. This is because it outlines which types of investments are and aren’t permitted as part of their portfolio. Additionally, it sets out in advance a mutually agreed-upon benchmark that can be used to evaluate the portfolio manager’s performance.
Cautious investors have the characterization of a below-average risk tolerance compared to other investors with similar circumstances.
Sometimes this is because they’ve accumulated their wealth through the receipt of gifts, inheritance, or by earning high compensation via employment.
None of the aforementioned circumstances required them to put their capital at risk. For this reason, these clients may have less awareness or knowledge about the relationship between risk and return 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. It 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. In addition, they are 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. It is an aid that can be used to help them to coach a client through a difficult market environment. Reminding them that risk is a necessary element of investing and the client agreed to accept some degree of volatility.
Individualist investors are usually a confident bunch. 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. Often, the conclusion is based on third-party research, such as an article they’ve read or something they’ve seen on television.
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.
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.