Risk profiling through behavioral finance
using behavioral biases to profile investors according to their risk tolerance
These days, realizing the investors’ thought process in their decision-making is no longer a nice-to-have skill. Conversely, current volatile markets and quick changes lead to forcing advisors to be able to diagnose irrational behavior and advise their clients accordingly.
In our last blog post, subjective risk perception, we discussed some personal elements that impact risk tolerance evaluation intensely. We mentioned that these hidden elements could be found as a part of behavioral finance, psychological issues, or financial planning section through evaluation. In this blog post, we want to go deep into behavioral finance and discuss risk tolerance measurement and the risk profiling process from a different perspective. We will introduce a new method that helps advisors categorize investors based on their risk tolerance scores and behavioral biases. This blog post is a summarization of two risk profiling books written by Michael Pomian. In these books, he tried to extract some behavioral biases from investors that impact their risk tolerance and, ultimately, their investment plans. He also provided some guidance by considering investors’ behavioral biases for advisors who help them create a consistent asset portfolio. We will discuss the guidelines in another blog post.
Behavioral finance attempts to understand and explain actual investor behavior, in contrast to theorizing about investor behavior. It differs from standard finance, based on assumptions of how investors and markets should behave. Behavioral finance is about understanding how people make individual and collective decisions. Understanding how investors and markets behave may be possible to modify or adapt to these behaviors to improve economic outcomes.
The investors’ thoughts and feelings can affect their behavior during the investment decision-making process. Past experiences and personal beliefs also unconsciously influence the investor’s behavior to the extent that even intelligent investors can deviate from logic. These influential factors are behavior biases, and we want to discuss them and elaborate on their effects on investors’ risk tolerance.
Michael Pompian introduced a way of categorizing behavioral biases in the first edition of his book Behavioral Finance and Wealth Management. He divided the biases into two categories which are listed below:
This bias has roots in how people think. Cognitive errors result from memory, and information-processing mistakes happen in our minds.
This bias has roots in how people feel. It is the result of reasoning influenced by feelings.
The distinction between cognitive and emotional biases is crucial when assessing risk tolerance. With emotional biases, advisors often need to adapt to these client behaviors due to the difficulty of altering investors’ feelings. However, with cognitive biases, the advisors have an opportunity to modify the clients’ thinking.
Known and Unknown Risk
Before going further, we should think about risks a bit more. Advisors will allocate the investors’ assets precisely when risks can be understood and measured. These risks can be divided into two categories based on behavioral finance concepts.
The known risk or normal risk: the risk we can comprehend easily and quantify using historical data from observations of financial markets.
The unknown risk or abnormal risk: the risk that occurs rarely and falls outside expectations.
People must consider their likely reactions to known and unknown risks to get a complete picture of their risk tolerance. Now, we know that to tolerate these two risks, the advisors must measure the risk tolerance and perception more accurately. In the [subjective risk perception] blog post, we showed a framework to estimate the total risk tolerance score, including risk perception. Besides the used factors, we mentioned that many others could be employed to evaluate the investors’ real risk tolerance.
In the following sections, we will introduce a new method that helps advisors categorize investors based on their risk tolerance scores and behavioral biases. Then, some guidelines are provided for practitioners to communicate better with investors and identify them perfectly.
Risk tolerance and behavior finance
Michael Pompian introduced the concept of behavioral investor types (BITs) in the book Behavioral Finance and Investor Types. He developed a process called Behavioral Alpha (BA) that identified BITs, which enhance the advisory process and allow advisors to work more effectively with their clients.
The BA method is a diagnostic process that categorizes clients into four groups. Bias identification will happen after the risk tolerance evaluation process and provide clear information for advisors to detect specific biases a client will likely have. We will describe this method in the following section.
Behavioral Investor Types (BIT)
The BITs were designed to help advisors quickly assess their investors’ types before recommending any investment plans. The BITs are not absolutes but guideposts when dealing with a client. This framework is a bottom-up orientation. It means that for advisors to diagnose behavioral biases, firstly, they should test for all behavior biases in the client before being able to use biased information to create a customized investment plan. Although this approach is accurate, some advisors may find it too time-consuming and complex. Therefore, Michael Pompian developed the Behavioral Alpha method, a simpler, more efficient, and top-down approach. It has three steps as follows:
Step 1: Identify a client’s active or passive traits
The portfolio construction process often begins with an interview that intends to realize the client’s objectives, constraints, and past investment experiences. During this process, the advisor should determine whether a client is an active or passive investor. Passive investors have tendencies toward certain investor biases, and active investors tend toward different biases. A questionnaire that probes the act’s active/passive nature is included below. A preponderance of “A” answers indicates an active investor, and “B” answers identify passive ones.
Have you earned the majority of your wealth in your lifetime?
Have you risked your own capital in the creation of your wealth?
Which is stronger: your tolerance for risk to build wealth or the desire to preserve wealth?
a. Tolerance for risk
b. Preserve wealth
Would you prefer to maintain a degree of control over your investment or prefer to delegate that responsibility to someone else?
a. Maintain control
Do you have faith in your abilities as an investor?
If you had to pick one of two portfolios, which would it be?
a. 80 percent stocks/20 percent bonds
b. 40 percent stocks/60 percent bonds
Is your wealth goal intended to continue your current lifestyle, or are you motivated to build wealth at the expense of your current lifestyle?
a. Build wealth
b. Continue current lifestyle
In your work or personal life, are you generally a self-starter in that you seek out what needs to be done and then do it, or do you normally take direction?
b. Take direction
Are you “income motivated,” or are you willing to put your capital at risk to build wealth?
a. Capital at risk
b. Income motivated
Do you believe in the concept of borrowing money to make money/operate a business, or do you prefer to limit the amount of debt you owe?
a. Borrow money
b. Limit debt
Step 2: Administer a risk tolerance questionnaire
Once the advisor has classified the investor as active or passive, the next step is to manage a traditional risk tolerance questionnaire to begin the process of identifying which one of the four behavioral investor type categories the client falls into. There are numerous risk tolerance questionnaires out there, so we do not include a new one here.
The advisor’s task at this point is to determine where the client falls on the risk scale in relation to how the client falls on the active/passive scale. The expectation is that active investors will rank medium-to-high on the risk tolerance scale while passive investors will rank moderate-to-low on the risk questionnaire. Naturally, this will not always be the case. If there is an unexpected outcome, then you should rely on risk tolerance as the guiding factor to determine which biases should be tested. Fig. 1 shows the general relation between the clients’ type and their risk tolerance score.
Step 3: test for behavioral biases
The third step in the process is to confirm the expectation that certain behavioral biases will be associated with unique behavioral investor types. For example, if an investor is passive, and the risk tolerance questionnaire reveals a very low-risk tolerance, the investor is likely to be a Passive Preserver (now simply called a Preserver). The task at this point is to give the client a test for biases that are associated with Passive Preservers. When the client is tested for behavioral biases of a Preserver, for example, and the test confirms that the client has these biases, then this will confirm the BIT diagnosis.
The list below demonstrates the different investors’ classes based on their BIT classification. Each group has its own biases that we will be tested by advisors after evaluating the investors’ risk tolerance.
General Type: Passive
Risk Tolerance: Low
Bias Types: Primarily Emotional
Behavioral Investor Type: Preserver
General Type: Passive
Risk Tolerance: Moderate
Bias Types: Primarily Cognitive
Behavioral Investor Type: Follower
General Type: Active
Risk Tolerance: Growth
Bias Types: Primarily Cognitive
Behavioral Investor Type: Independent
General Type: Active
Risk Tolerance: Aggressive
Bias Types: Primarily Emotional
Behavioral Investor Type: Accumulator
Illusion of control
Fig. 2 illustrates the entire diagnostic process in a flowchart. According to this process, the first step is identifying clients’ orientation based on their type and risk tolerance. After that, we conduct a bias orientation test, which is a test for one or two main biases for each group based on the list above. By doing so, advisors and investors can feel confident that they have identified a key orientation and are working through the effects of a few core biases of each BIT.
Remember that the main purpose of identifying BITs and the associated biases is to determine what behaviors might be present that could prevent a client or investor from reaching their financial goals.
After all these steps, the advisors will have extensive knowledge about the investor’s orientation and biases. Now, it’s time to convey some information and new knowledge to the investor to clear all circumstances that might happen throughout the investment. For this knowledge transformation, there is a guideline for practitioners that explain how to deal with different clients. We will discuss the guideline in another blog post in this series.
Michael M. Pompian (2012). Behavioral Finance and Investor Types: Managing Behavior to Make Better Investment Decisions. Wiley Finance.
Michael M. Pompian (2011). Behavioral Finance and Wealth Management: How to Build Investment Strategies That Account for Investor Biases. (Second edition). Wiley Finance.
Thanks for reading Eveince's Blog! Subscribe for free to receive new posts straight into your inbox.