Having a good understanding of an investor's risk tolerance is crucial to any successful advisor/client relationship. It is also a key component of any good investment policy statement. Investment advisors usually explore things like age, size of investment portfolio, expected retirement date and future earnings and financial obligations to gauge an investor's risk tolerance. These quantifiable aspects can tell us a lot about an investor's ability to take investment risk, but what about their willingness?
The importance and complexity of an investor's willingness to take risk is one of the many differentiating factors between managing investment portfolios for large institutions and managing them for individual investors. Because most investment products and programs are developed by institutions for institutions, they fail to address this "human side" of risk tolerance. Personality typing is a new tool that is helping investment advisors better understand an individual investor's willingness to take risk and behavioral tendencies. Read on to learn more about what personality typing is, how it can help you gauge risk tolerance, and how it can give you insight into an investor's decision-making tendencies.
Before we discuss the process of personality typing it is important to understand that individual investors are unique and can't always be perfectly placed into a specific personality type or category. However, personality typing can help facilitate discussions with investors about risk tolerance and can give you insight into investment strategies that may fit their psychological profile.
The first step in personality typing is to understand the investor's personal background. Interviewing an investor about their life experiences, inherited behavioral traits, career paths, and their current investment portfolio can tell you a lot about their willingness to take risk and whether or not they have a tendency to make emotional decisions regarding their investments. Some investment management firms have developed proprietary client questionnaires to help them with the standardization of this process. Once you have a good understanding of the investors background you can usually place them into a broad personality type.
The CFA Institute's Candidate Body of Knowledge lists the four main personality types as cautious, methodical, spontaneous, and individualist. They are categorized below by their willingness to take risk.
Lower Willingness to Take Risk
Cautious investors make decisions based primarily on feelings and are very sensitive to investment losses. Fear drives their investment decision making process. They have trouble making proactive decisions regarding their investments and do not trust the advice of others. For this reason, their portfolios usually have low turnover and include mostly safe investments. Possible examples of investors that tend to have cautious personalities might include retired elementary school teachers and elderly widows. Forget the clichés and uncover how much volatility you can really stand.
Methodical investors follow a disciplined, mechanical investing strategy. They make investment decisions based on hard facts and have the tendency to nitpick about small details. They rely heavily on investment research and are not emotional about their investment decisions. They tend to be disciplined investors which can cause them to have a lower risk tolerance. Possible examples of investors that tend to have methodical personalities could include architects and engineers.
Higher Willingness to Take Risk
Spontaneous investors make investment decisions based on feelings and make them frequently. They are always second guessing themselves and the advice of others and often chase investment fads. For this reason, their investment portfolios usually exhibit high portfolio turnover and may include riskier investments. Possible examples of investors that tend to have spontaneous personalities might include a commission-based salesperson or a young trust fund heir. A high-risk security can reduce risk overall.
Individualist investors make decisions based on hard facts and do not second guess their investments often. They exercise independent thinking and put a great deal of trust in their investment research. For this reason, they are usually less risk averse than others. Individualist investors are usually self-made and hard working. Possible examples of investors that tend to have individualist personalities could include a small business owner or an upper level manager in a large corporation.
Arriving at Total Risk Tolerance
An investor's personality type and willingness to take risk can be used in conjunction with information regarding their ability to take risk to better judge their total risk tolerance. Occasionally, an investor's willingness will vary greatly from their ability to take risk. When this occurs, further education about capital markets and investment risk may be required to resolve the issue.
The Bottom Line
When dealing with individual investors, building a truly customized investment portfolio involves a good understanding of both their ability and willingness to take risk. Most generic investment programs and financial products, like target-date funds, do not properly address an investor's willingness to take risk. The growing acceptance of behavioral finance makes it crucial for investment advisors to use new tools like personality typing to help them better understand an investor's risk tolerance. Although self-diagnosis may not always be healthy, personality typing can also be used as a tool to give you insight into your own investment biases and willingness to take risk.