Behavioral finance combines psychology and economics to explain why and how investors act and to analyze how that behavior affects the market. This is in conflict with the perspective of efficient market theory, which maintains that market prices are based on rational foundations, like the fundamental financial health and performance of a company. One of the main objectives of behavioral finance is thus to explain why people make irrational financial decisions. If we are able to pre-emptively understand these biases then we will hopefully be less likely to fall victim to the mistakes that they dispose us to.
Because of personality differences, we all make decisions in different ways, utilising different pieces of the available information to come to a variety of differing conclusions. In recent decades a lot of research has been conducted to enhance our understanding of why people manage investments in different ways. “BB&K Five Investor Personality types” developed by Thomas Bailard, David Biehl and Ronald Kaiser classify investor personalities along two axes-level of confidence and method of action.
Based on where you fall on the axis we can make a number of assumptions about what may or may not be a suitable investment, your objectives, and your attitude towards risk.
Adventurers are not risk averse and will commonly make large investments because they are generally confident individuals. From an advisory point of view they are sometimes difficult to counsel because they may have their own ideas of preconceptions about investing. They may purchase volatile assets and also experience volatility in their personalities too.
This person likes to be involved and close to the action. They often suffer from FOMO (fear of missing out). They do not have any specialist knowledge about investment and can sometimes be lead astray. They are ordinarily not averse to risk but sometimes experience buyers remorse when the assets that they purchase have temporarily poor performance.
As people near retirement they will often assume this personality profile. Eventually (some of us sooner than others) people come to understand that they only have a limited time span to accumulate money that will have to serve them into old-age, long after their salaries have stopped. These investors are interested in preserving their assets and are both risk and volatility averse. Guardians lack confidence in their ability to forecast the future and will often seek professional advice for their investment needs.
The Straight Arrow
This group of people are well balanced and do not fit in any one particular quadrant. These people are centrists and are what we look upon as the average investor. They are willing to be exposed to a certain degree of risk to achieve their objectives and are able to make decisions un-emotionally where it comes to their personal finances.
This group of people are typified by the small business owner or independent professionals like lawyers of accountants. They are highly independent and self-reliant. Their personalities are often careful, methodical and analytical. They often have a professional specialist knowledge in one area and are extremely rational. These types of clients are particularly welcomed by investment advisors.
Risk Profile And Asset Selection
Although the personality type model allows us to make inferences about what assets an investor might be inclined to buy, it is important to have a firm understanding of risk to underlay the decision making process.
Discussions with an adviser will define a grouping of suitable asset classes and individual assets for the client based upon their objectives and restrictions. Fundamentally, two criteria will inform the investment process.
Investment time horizon/ tenure
How long can you leave your money invested for? If you invest one million yen today but you require it back in 12 months time, investing in equity markets where there will be short-term price volatility is a bad idea. The relationship between potential returns and price volatility (standard deviation, or risk) is linear. If your time horizon is short you may be forced to sell your investments at a loss. Ordinarily, those with a less one year time horizon should limit their investments to cash, and cash deposits. If your objectives are more long-term (e.g. retirement, education fee planning..) you can afford to subject your capital to more price uncertainty in aim of receiving larger returns. In this instance, your range of ‘suitable’ assets will be much larger and you can be more creative.
Liquidity and loss tolerance
The more money you have, the more risk you are able to take. The inverse is duly correct. If you do not have a lot of liquidity (i.e liquid cash), putting the majority of it at risk will be a bad idea in the event that your investments experience losses. If you are investing the correct proportion of your asset base then you will not be so concerned when a portion of your portfolio experiences temporary losses and you will not be inclined to panic sell. Care should be taken when choosing investments to insure that the liquidity profile of the investment (i.e how easy it is to sell and release funds) is matched to the liquidity needs of the investor.
[ Sources ]
– Thomas Bailard, David Biehl and Ronald Kaiser, Personal Money Management, 5 th ed. (Chicago: Science Research Associates, 1986)
– Goldberg, J. and Von Nitzsch, R. (2001) Behavioral Finance . John Wiley and Sons.
– Markowitz, H. (1952) Portfolio Selection, The Journal of Finance , VII, 77 – 98.