Michael Pompian, author of two highly regarded books on behavioral finance and director of the private wealth practice at Hammond Associates in St. Louis, Mo., believes that determining behavioral investor types and investor biases is the most important aspect of behavioral finance as it applies to financial planning.
If financial advisors are able to understand what type of investor their client is and what biases are driving their behavior, Pompian believes that they will not only be able to better serve their clients, but these clients themselves will be able to get a clearer sense of their own psychology and mental make-up, and how to either let them or not let them impact their long-term financial goals.
“Both advisors and clients need to be on the same page with this and the end goal is to have the client realize what personality type they are so that they can maximize their financial goals and results,” Pompian says.
If an advisor can successfully determine what personality type his or her clients have and what behavioral biases they exhibit, he or she can have a better chance of helping clients avoid irrational decisions that can impact the overall performance of their investment portfolios in the long-term. An advisor can step in and intervene, moderate a client’s behavior, if his biases are dominating his decisions and threatening to undermine his financial goals, Pompian says. Conversely, advisors can also emphasize or lend support to a particular bias if it can enhance the performance of a client’s portfolio at certain times.
Either way, the first task for any advisor hoping to successfully implement the principles of behavioral finance is to figure out what these biases are. Pompian’s research through the years has led him to determine that there are two broad categories of biases that drive investor behavior: Cognitive biases (those that stem from faulty reasoning and can be rectified by simply providing better information to an investor) and emotional biases (which come from impulsive feelings or intuition and as such, are harder to rectify). Both categories can be further broken down into individual biases like loss aversion (the tendency to feel the pain of losses more than the pleasure of gains); overconfidence (the tendency to overestimate investment knowledge); regret (the tendency to feel deeply disappointed for having made incorrect decisions) and lack of self control (the tendency to spend today rather than to save for tomorrow).
Pompian says that he has identified 20 such biases and he has developed a test with which he can determine what biases his clients have. He then overlays this test with another test designed to see what kind of personality an individual has, so that he can figure out how best to relate to them in order to get the most out of their relationship: “I want to find out what they’re like, how they like to be related to, how they like to get their information," he says. “I want to know, for example, whether they are data-oriented or whether they prefer to have a close, personal relationship with their advisor or whether they like to do their own thing.”