Clients have various characteristics that influence their investment decisions. Many advisors understand that a significant part of the value of working with clients is helping them manage their mindset when it comes to investing. However, understanding investor psychology requires knowing what to measure. In the following text, we will examine several characteristics that can influence a client’s overall investor psychology, also known as behavioral risk tolerance. By measuring investor personality, advisors can identify which clients may be prone to cognitive biases. These insights can also help advisors coach and educate clients to become effective investors.
Understanding Stable Investor Personality Characteristics
Risk Personality
When we think of “investor psychology,” risk personality may often come to mind first. This factor refers to the client’s propensity and desire to make decisions without a clear and guaranteed outcome.
Risk Preference
Most risk tolerance measures measure risk preference, and most literature supports this component being critical to overall investor personality. This factor refers to a general preference for and experience with a certain level of risk in one’s portfolio. Side note: the trouble with only measuring this factor in risk tolerance is that many clients unfamiliar with investing don’t really understand what “different levels of risk” even means.
Volatility Composure
Investors differ in how they experience fear, anxiety, or worry. Volatility composure is the emotional side of investing. This personality factor is closely related to The Big Five factor of Neuroticism (or its polar opposite, Emotional Stability). This factor refers to an investor’s ability to emotionally manage declines in the value of investments or the market in general.
Investor Confidence
We find that two factors influence an investor’s confidence. One is the client’s general self-esteem (e.g., “I’m a good or capable person.”). The other is self-efficacy, or the investor’s belief that she is proficient or capable when it comes to making investment decisions. Both factors impact outcomes like trading. Investors who are high on the confidence factor, while also being low on Volatility Composure and Judgment (see below), can be particularly prone to investing-related biases, like herd mentality or loss aversion.
Investor Judgment
Attitudes towards and beliefs about investing also influence how investors make decisions. Investor judgment refers to how a client views long-term investing. Clients who tend to enjoy trading or view investing more like gambling tend to have a harder time investing for the long-term.
Not So Stable: Investor Perceptions or Mood
In addition to understanding an investor’s stable characteristics when it comes to investing, advisors should also assess a client’s current feelings or mood about investing. We refer to this as risk perception, which can change frequently, depending on what’s happening in the markets or what happened in your client’s day.
If you’re measuring investor personality, why do you need to measure investor perceptions? Advisors use this insight to demonstrate empathy and understanding when presenting an investment strategy or communicating that a change is needed.
Measuring Investor Personality
In our white paper on understanding great investors, we spelled out how clients and advisors can benefit from assessing investor personality at the start of the relationship. There are key criteria to consider when deciding on how to measure risk tolerance, including the science behind the test, how the test was created, and if the test is relevant to clients. And, not all risk tolerance questionnaires measure stable investor characteristics like the five mentioned above.
Understanding investor psychology first requires measuring personality and perceptions. These insights can be used to build awareness, improve decision-making, and enhance financial wellness. For the advisor, the insights can serve as a catalyst for engagement, personalization of the client experience, and coaching.