Behavioural FinanceFinance & Banking

Online Finance Course: Behavioral Finance and Investor Types – Managing Behavior to Make Better Investment Decisions

Behavioral Finance and Investor Types - Managing Behavior to Make Better Investment Decisions

Course Content

Part One: Introduction to Behavioral Finance

Chapter 1: Why Reaching Financial Goals Is Difficult

NONFINANCIAL EXAMPLES OF SELF-DEFEATING BEHAVIOR
FINANCIAL EXAMPLES OF SELF-DEFEATING BEHAVIOR
SUMMARY

Chapter 2: Overview of Behavioral Finance

BEHAVIORAL FINANCE: MICRO VERSUS MACRO
STANDARD FINANCE VERSUS BEHAVIORAL FINANCE
THE ROLE OF BEHAVIORAL FINANCE WITH PRIVATE CLIENTS
PRACTICAL APPLICATIONS

Chapter 3: The Building Blocks: Behavioral Biases

COGNITIVE BIASES
EMOTIONAL BIASES
SUMMARY

Part Two: Personality Theory

Chapter 4: Introduction to Personality Theory

HISTORY OF PERSONALITY THEORY
FOUR MAIN PERSONALITY THEORIES

Chapter 5: The History of Personality Testing

TYPES OF PERSONALITY TESTS
SUMMARY

Chapter 6: The Behavioral Investor Type Framework

REVIEWING THE ORIGINAL PROCESS
THE BEHAVIORAL ALPHA PROCESS: A TOP-DOWN
APPROACH
UPDATES TO THE PREVIOUS MODEL
UPDATED BIT THEORY AND APPLICATION
SUMMARY

Chapter 7: Behavioral Investor Type Diagnostic Testing

STEP 1: BIT ORIENTATION QUIZ
STEP 2: BIAS IDENTIFICATION QUIZ
SUMMARY

Part Three: Explanation of the Behavioral Investor Types

Chapter 8: The Preserver

UPSIDE/DOWNSIDE ANALYSIS
BIAS ANALYSIS
OTHER BIASES
ADVICE FOR PRESERVERS

Chapter 9: The Follower

UPSIDE/DOWNSIDE ANALYSIS
BIAS ANALYSIS
OTHER BIASES
ADVICE FOR FOLLOWERS

Chapter 10: The Independent

UPSIDE/DOWNSIDE ANALYSIS
BIAS ANALYSIS
ADVICE FOR INDEPENDENTS

Chapter 11: Chapter The Accumulator

UPSIDE/DOWNSIDE ANALYSIS
BIAS ANALYSIS
OTHER BIASES
ADVICE FOR ACCUMULATORS

Part Four: Plan and Act

Chapter 12: Capital Markets and Asset Classes

OVERVIEW OF ASSET CLASSES
PUBLICLY TRADED EQUITY INVESTMENTS (STOCKS)
FIXED INCOME INVESTMENTS (BONDS)
HEDGE FUNDS
REAL ASSETS
SIMPLE PORTFOLIO CONSTRUCTION
SUMMARY

Chapter 13: Chapter What Is Asset Allocation?

THE IMPORTANCE OF ASSUMPTIONS
THE IMPORTANCE OF STRATEGIC ASSET ALLOCATION
CONSIDERATIONS FOR INDIVIDUAL INVESTORS
WHY ASSET ALLOCATION IS SO IMPORTANT
SUMMARY

Chapter 14: Financial Planning: A Crucial Step

WHAT IS FINANCIAL PLANNING?
WORKING WITH A FINANCIAL PLANNER
WHAT IS A CERTIFIED FINANCIAL PLANNER?
WHO CAN PROVIDE FINANCIAL PLANNING SERVICES?
SUMMARY

Chapter 15: Investment Advice for Each Behavioral

Investor Type

FOUNDATIONS OF BEST PRACTICAL ALLOCATION
GUIDELINES FOR DETERMINING WHEN TO MODERATE AND WHEN TO ADAPT
BEST PRACTICAL ALLOCATION FOR PRESERVERS
BEST PRACTICAL ALLOCATION FOR FOLLOWERS
BEST PRACTICAL ALLOCATION FOR INDEPENDENTS
BEST PRACTICAL ALLOCATION FOR ACCUMULATORS

 

Foreword

Fishermen often use the expression “to set the hook” and that is what I hope to do for Behavioral Finance and Investor Types. Michael Pompian graciously asked me if I would write this Foreword and, in a blink, I agreed. Why? Because the investing pond is full of investors who need to take the hook Michael is presenting here.

You are about to read and solve a mystery of sorts. It lifts the curtain on what lurks behind investment choices—improperly formulated choices that so often derail expectations. This book takes the often tedious and proverbial “scraping and sanding before painting” and makes it the intriguing cornerstone of investing.

Ben Franklin, always insightful about visionaries, wrote in the 1769 Farmers’ Almanac, “There are three things extremely hard: steel, a diamond, and to know one’s self.” To make sound choices, you must know yourself in order to know what decisions your personality can withstand when building and implementing an investment policy and process.

You must know yourself, or the organization for which you serve, well enough to convey the beliefs, preferences, and biases about those whom you have chosen to advise you on investment decisions. This includes brokers, consultants, investment advisors, and so on. To be unable to do so is a prescription for inappropriate asset selection and portfolio composition—a far too common outcome. This is true from both an expected return and an expected risk perspective.

It is hard to imagine how much effort and knowledge was required to create this book. To focus effectively on what drives different types of personalities and match those personalities with an appropriate, fitted investing solution requires a long and patient observer and practitioner, like Michael Pompian.

After many years in the consulting business, Michael has honed a deep psychological understanding of investor personalities, and accurately characterizes and classifies them into types. He is a rare breed with his deep knowledge of what drives investors and what drives portfolios—an elementary alignment that is the missing ingredient for the vast majority of investors—both individuals and institutions.

Behavioral Finance is about the psychology that drives financial or investment choices in an uncertain future environment. Behavioral finance has been mostly under the wing of the academic community whose research has become prolific enough to offer a source of meaning and direction for investors.

Twenty years ago behavioral finance was mostly a nebulous, certainly unrequited, and scattered collection of research by those who dared to tamper with classical views of finance. Recognizing the overwhelming role of psychology in decision making has forever changed the role of individuals and groups in making investment choices!

Way back in the 1930s, John Maynard Keynes wrote of “animal spirits,” a now bantered catch-all for our behavior as investors. Then, in 2002, Daniel Kahneman put behavioral finance front and center by winning the Nobel Prize in Economics. Kahneman is a psychologist and points out that he has never taken a course in economics. Since that event, interest in behavioral finance has catapulted to become a source of rationale for investors’ decisions.

Michael has done yeoman’s service in taking years of academic research and his own practitioner insights to illuminate the mandatory need to understand the virtues of the physiological implications of choice. He is bringing these essential findings to the forefront of untangling everyday investment thinking with the clear mandate of implementing sound investment decisions.

His combined knowledge of the inherent drivers of investor behavior, and years of careful observation, clearly illuminates that shoe sizes, so to speak, vary a great deal. He has effectively “typed” investors—be they individuals or institutions—as a way to narrow and clarify what choices would be best for them. This “sanding and scraping” provides compatibility between investor expectations and ultimate results.

So, who should read this book? If we start with every investor and every consultant or broker, the answer is all of them. The psychological insights into personality types developed from the building blocks of beliefs, preferences, and behavioral biases are now essential for developing appropriate recommendations.

All the agents involved in this process now realize what Ben Franklin described as one of the hardest things in life—to know one’s self. Portfolios must reflect both the personality of their clients and their needs in order to create a thoughtful, sound investment program. Otherwise, investors and their advisors will join the majority of those who do not have the benefit of the practical blueprint that Behavioral Finance and Investment Types so effectively provides.

 

AN IMPERFECT SCIENCE

Although it might seem to be an impossible task to try to categorize people by their behaviors, many thoughtful people have tried to do so. Many of the people who have tried to do this are quite well known—Freud, for example—while others are quite unknown.

Several chapters of this book are devoted to an historical view of personality theory and the research that has gone into this subject. After reading this work, what one quickly realizes is that the study of personality is an imperfect science. Unlike hard sciences like physics and chemistry, which have elegant mathematical formulas for explaining naturally occurring phenomena, social science is less precise.

This book is certainly closer to being imprecise than it is to being precise based on this fundamental idea. The ideas in the book are an attempt to categorize investors by their behavior—something that by definition cannot be precise. Therefore, the book should be used to gain insights into one’s basic

behaviors and learn how to counteract the potentially negative outcomes associated with biased investment decision making. Don’t get too caught up in the categories or classifications. Moreover, identifying your own type is only valuable if you can do something with the information!

In order to do something with the categorization of investors by their behavior, I created a term called “Behavioral Investor Types” (also known as BITs), which is used throughout the book. There are four BITs used to describe the most commonly found investor personalities.

Undoubtedly you will find some discrepancies—but fret not. BITs were created to make behavioral finance easier to apply in practice. Before jumping into the nuts and bolts of how to diagnose clients into BITs, as is done in the book, it is important for readers to understand the depth of thought that went into creating them; I will do so because I want you to feel confident about using this material in practice.

BITs build on key concepts I outlined in some of my early papers, including one published in the Journal of Financial Planning in March 2005 entitled “The Future of Wealth Management: Incorporating Behavioral Finance into Your Practice,” as well as my book, published in 2006, entitled Behavioral Finance and Wealth Management, and a subsequent second edition of the same book published in 2012. In those two works, I outline a method of applying behavioral finance to private clients in a way that I now refer to as “bottom-up.”

“Bottom- up” means that in order for an advisor to diagnose and treat behavioral biases, he or she must test for all behavioral biases in the client first, and then determine which ones a client has before being able to use bias information to create a customized investment plan.

For example, in Behavioral Finance and Wealth Management, I describe 20 of the most common behavioral biases that an advisor is likely to encounter, explain how to diagnose a client’s biases, show how to identify types of biases, and finally show how to plot this information on a chart to create the best practical allocation for the client. Some investors and advisors may find this bottom-up approach too time-consuming or complex. With the introduction of BITs in this book, however, I take a simpler, more efficient approach to bias identification.

The BIT identification process is a multi-step diagnostic process that results in clients being classified into one of four behavioral investor types. Bias identification, which is done near the end of the process, is narrowed down for the advisor by giving the advisor clues as to which biases a client is likely to have based on the client’s BIT.

BITs were designed to help advisors make rapid yet insightful assessments of what type of investor they are dealing with before recommending an investment plan. The benefit of defining what type of investor an advisor is dealing with up-front is that client behavioral surprises that result in a client wishing to change his or her portfolio that arise as result of market turmoil can be mitigated.

If an advisor can limit the number of traumatic episodes that inevitably occur throughout the advisory process by delivering smoother (read: expected) investment results because the advisor had created an investment plan that is customized to the client’s behavioral make-up, a stronger client relationship is the result.

BITs are not intended to be absolutesbut rather guideposts to use when making the journey with a client; dealing with irrational investor behavior is not an exact science. For example, an advisor may find that he or she has correctly classified a client as a certain BIT, but finds that the client has traits (biases) of another.

In the book, I provide descriptions of the four behavioral investor types: Preservers, Followers, Individualists, and Accumulators. The book will include a diagnostic for isolating behavioral biases, and advice for dealing with each BIT.

Each BIT is characterized by a certain risk tolerance level and a primary type of bias—either cognitive (driven by faulty reasoning) or emotional (driven by impulses or feelings). One of the most important concepts advisors should keep in mind as they go through the book is that the least risk-tolerant BIT and the most risk-tolerant BIT are driven by emotional biases, while the two BITs in between these two extremes are mainly affected by cognitive biases.

Emotional clients tend to be more difficult clients to work with, and advisors who can recognize the type of client they are dealing with prior to making investment recommendations will be much better prepared to deal with irrational behavior when it arises.

At the end of the day, the purpose of classifying your clients into BITs is to build better relationships with them. The essence of being a great advisor is to be a great people person.

Naturally, one absolutely needs to be technically competent in their chosen specialty in the business—but to get really great one needs to be able to sense how a relationship is going and make strides to build the relationship, and at the same time be versatile enough to work with people from all walks of life and backgrounds.

This is the fun part of working in the investment advisory business for some people; it is for me. For those of you who are familiar with my work, you will know that I am a big believer in the power of behavioral finance to help explain investor behavior to improve investment outcomes.

The key benefit of learning the details of behavioral finance is that one can know when one is making biased investment decisions or help clients to see that they are making biased decisions. Understanding how people behave can be a critical component to not only improving investment outcomes for oneself but also in building lasting relationships with others.

 

WHO SHOULD USE THIS BOOK?

The book was originally intended as a handbook for wealth management practitioners who help clients create and manage investment portfolios. As the book evolved, it became clear that individual investors could also greatly benefit from it. The following are additional target audiences for the book:

  • Traditional wire-house financial advisors. A substantial portion of the wealth in the United States and abroad is in the very capable hands of traditional wire-house financial advisors. From a historical perspective, these advisors have not traditionally been held to a fiduciary standard, as the client relationship was based primarily on financial planning’s being “incidental” to the brokerage of investments. In today’s modern era, many believe that this will have to change, as “wealth management,” “investment advice,” and brokerage will merge to become one. And the change is indeed taking place within these hallowed organizations. Thus, it is crucial that financial advisors develop stronger relationships with their clients because advisors will be held to a higher standard of responsibility. Applying behavioral finance will be a critical step in this process as the financial services industry continues to evolve.
  • Private bank advisors and portfolio managers. Private banks, such at U.S. Trust, Bessemer Trust, and the like, have always taken a very solemn, straight-laced approach to client portfolios. Stocks, bonds, and cash were really it for hundreds of years. Lately, many of these banks have added such nontraditional offerings as venture capital, hedge funds, and others to their lineup of investment product offerings. However, many clients, including many extremely wealthy clients, still have the big three—stocks, bonds, and cash—for better or worse. Private banks would be well served to begin to adopt a more progressive approach to serving clients. Bank clients tend to be conservative, but they also tend to be trusting and hands-off clients. This client base represents a vast frontier to which behavioral finance could be applied because these clients either do not recognize that they do not have an appropriate portfolio or tend to recognize only too late that they should have been more or less aggressive with their portfolios. Private banks have developed a great trust with their clients and should leverage this trust to include behavioral finance in these relationships.
  • Independent financial advisors. Independent registered representatives (wealth managers who are Series 7 registered but who are not affiliated with major stock brokerage firms) have a unique opportunity to apply behavioral finance to their clients. They are typically not part of a vast firm and may have fewer restrictions than their wire-house brethren. These advisors, although subject to regulatory scrutiny, can for the most part create their own ways of serving clients; and with many seeing that great success is growing their business, they can deepen and broaden these relationships by including behavioral finance.
  • Registered investment advisors. Of all potential advisors that could include behavioral finance as a part of the process of delivering wealth management services, it is my belief that registered investment advisors (RIAs) are well positioned to do so. Why? Because RIAs are typically smaller firms, which have fewer regulations than other advisors. I envision RIAs asking clients, “How do you feel about this portfolio?” “If we changed your allocation to more aggressive, how might your behavior change?” Many other types of advisors cannot and will not ask these types of questions for fear of regulatory or other matters, such as pricing, investment choices, or others.
  • Consultants and other financial advisors. Consultants to individual investors, family offices, or other entities that invest for individuals can also greatly benefit from this book. Understanding how and why their clients make investment decisions can greatly impact the investment choices consultants can recommend. When the investor is happy with his or her allocation and feels good about the selection of managers from a psychological perspective, the consultant has done his or her job and will likely keep that client for the long term.
  • Individual investors. For those individual investors who have the ability to look introspectively and assess their behavioral biases, this book is ideal. Many individual investors who choose either to do it themselves or to rely on a financial advisor only for peripheral advice often find themselves unable to separate their emotions from the investment decision making process. This does not have to be a permanent condition. By reading this book and delving deep into their behaviors, individual investors can indeed learn to modify behaviors and to create portfolios that help them stick to their long-term investment programs and, thus, reach their long-term financial goals.

 

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