Comparing individual investors to institutional investors is like comparing apples to oranges. While any individual polled on the street may claim to act independently and make current investment decisions based solely on a long-term plan, it is rare to see this in practice. Individual investors differ from institutions in their investment horizons, how they define risk and how they behave in response to changes in the economy and investment markets. This does not mean that individual investors are any less successful than institutional ones at investing - just that their style of investing presents unique challenges.
Types of Investors
Many attempts have been made to categorize the characteristics of individual investors; the Bailard, Biehl and Kaiser (BB&K) model provides some help. Their work pioneered areas of what is now called behavioral finance. (Curious about how emotions and biases affect the market? Find some useful insight in Taking A Chance On Behavioral Finance and Gauging The Market's Psychological State.)
BB&K has defined individual investor types as follows:
- Individualist: careful, confident and often takes a do-it-yourself approach
- Adventurer: volatile, entrepreneurial and strong willed
- Celebrity: follower of the latest investment fad
- Guardian: highly risk averse; wealth preserver
- Straight Arrow: shares the characteristics of all the above equally
Figure 1, below, depicts BB&K's early attempt to place these five individuals into a quadrant of style.
|Source: Bailard, Biehl & Kaiser|
The concept of compartmentalizing an individual investor has been around for a long time. Financial planners and advisors regularly draw up lengthy questionnaires to gather information in order to derive the appropriate investment strategy for each client. Unfortunately, behavioral finance has some gray areas.
One major unpredictable issue in this area of study is that it is human nature to change. Investors evolve throughout their investing life cycles, whether they are in their accumulation, consolidation, spending or gifting phases. Also, investors can change investment styles over time. This means that while an investor may start out as a guardian, he or she may move toward being a straight arrow and then on to an adventurer without even knowing it. (Learn how to weather the phases of your investing journey in The Seasons Of An Investor's Life and The Stages Of Industry Growth.)
One of the biggest differences between institutional and individual investors lies in how individuals define risk. While institutional investors define risk quantitatively, individuals tend to base risk solely on how much money they have lost. This adds a qualitative perspective to risk tolerance and moves the entire category of risk into losses. On the flip side, when an individual makes a substantial amount of money in a short time period, he or she will often ignore that same risk or volatility that put those gains in the portfolio. (Learn more about risk tolerance in Risk Tolerance Only Tells Half The Story and Personalizing Risk Tolerance.)
An investment horizon is the length of time over which one plans to invest or the entire life cycle of the investment portfolio. With an institution, an investment time horizon can be indefinite. In the case of a defined benefit plan or an endowment, assets will continually be placed into and paid out of the fund for as long as the plan is in effect.
For individuals, investment time horizon is one of the most misunderstood concepts. It may be interpreted as the length of time one works for a company with assets in a 401(k) or as a retirement date. In actuality, an individual's time horizon is much longer. It's at least as long as the expected life span of the individual, and possibly longer when considering the horizon of one's estate. For example, if an investor gathers pension plan assets during her working years and builds wealth for the next generation, then the time horizon for her total wealth should match that of the beneficiaries of her estate, extending the horizon considerably. (To learn more, read Getting Started On Your Estate Plan and Six Estate Planning Must-Haves.)
Lack of Understanding
Individuals may not venture out of their comfort zones into areas they don't understand. This lack of familiarity may keep an individual investor from adding asset classes that may help increase overall returns or reduce risk. An institutional investor has the benefit of vast resources of information and a high sophistication level, making it less likely to avoid unfamiliar areas. (For further reading, see Diversification: It's All About (Asset) Class and Asset Allocation: One Decision To Rule Them All.)
Fear and Greed
To say that either fear or greed is unavoidable is an understatement. When dealing with human reactions to investing, it is a natural instinct to at least feel the effects of a bull market or bear market. The information about the current state of the markets, whether good or bad, is almost inescapable. CNN, CNBC, FNN, BNN and even NPR flood the airwaves with market updates that can lead individuals to react to the news. (For more on fear and greed, see When Fear And Greed Take Over and Master Your Trading Mindtraps.)
Individuals may have an opportunity to be contrarian investors and go against the grain, but most will find it difficult to invest in an asset class that is currently losing value. Or, they may easily fall prey to the me-too attitude and jump on the most recent upward-moving trend. Investors can also fall into the trap in which painful, long-term memories preclude them from pursuing good opportunities. For example, how many times have you heard people say that they would never invest in an asset class because they or someone they know previously lost money there?
Developing successful investment strategies for individual investors (as opposed to institutional ones) presents specific challenges. While there have been attempts like the Bailard, Biehl & Kaiser model to compartmentalize individual investors, it is difficult to predict human nature. Individual investors also evolve throughout their investing life cycles and become more sophisticated and perhaps less risk averse as their wealth levels change and markets fluctuate. Understanding the unique features of individual investors can guide both professional advisors and the investors themselves toward more profitable investing decisions.