Who are you?

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In this internet age, where information is widely available at the click of a button, one would be forgiven for thinking that making good financial decisions is easy.  It is possible to go online and compare financial products, buy investment funds or insurance and even apply for a mortgage or a loan.  What is rarely considered is both the context in which those decisions are made and the psychology of the person making them.  You can never have enough information about yourself, your family, friends, colleagues and even professional advisers.  As Benjamin Disraeli said, "As a general rule, the most successful man in life is the man who has the best information”.  The key is to have the most accurate and relevant information, particularly about yourself!

Can you predict how you would behave if there were to be a negative stockmarket event tomorrow?  Do you approach financial decisions in a rational and logical way, or are you more intuitive and emotional?  What were your best and worst financial decisions and why do you think that was the case?  Is money a source of pain or pleasure for you and what impact does that have on your financial decision making and overall quality of life?  What does the term ‘risk’ mean to you?  Does it conjure up excitement or trepidation?

Some people who are high earners spend all (and sometimes more than) they earn and consequently never build wealth.  On the other hand there are people who have modest earnings who build serious wealth because they spend very little.  A self-made person who has worked hard all their life and amassed a reasonable amount of wealth might find it hard to justify spending money.  A third generation inheritor of wealth, on the other hand, might find it easy to blow money on things they don’t need or even want.

Knowing your ‘financial personality’ is the key to living the life you really want and to developing and sticking with a financial plan that will ensure that money enables you to be true to that ideal.  Your financial personality is your unique combination of natural ‘hard-wired’ and learned behaviours as they relate to money.  Your behavioural characteristics will have a big impact on how you see the world, process information (or block it out) and how you react to messages from your family, friends and colleagues.  If you are employing a professional financial adviser it can mean the difference between a successful long term relationship or not.

Leading the life you really want is achieved by uncovering your  ‘financial personality’ and then aligning it to a unique life plan.  The starting point is for you to understand the core of who you are and then using that knowledge to make successful financial decisions.  Figure 1 details a number of key aspects of an individual’s ‘financial personality’:




 

Figure 1 – Financial personality characteristics

Source: Financial DNA

Natural behaviour is what we are born with - the factory settings – it is very stable and highly predictable over time and usually shapes how people respond to the world around them.  Natural behaviour usually surfaces when a person is under pressure - whether positive or negative.  Learned behaviours, on the other hand, are those which are shaped by an individual’s life experiences, education, environment and previous financial successes and failures and this creates your attitudes, beliefs and values.

Because natural behaviour is instinctive, it is the ingrained response that shapes how you respond to external factors and scenarios.  At its most basic and extreme level, these responses are triggered by the amygdala in the back of your brain, which might otherwise be described as your ‘fight or flight’ decision box.  Your natural behaviour is often masked by learned behaviour and as such it can become ‘buried’ and less obvious over time.  Knowing your natural behaviour factors and how these surface in a stress or striving scenario is key to sticking with a financial plan and avoiding ‘noise’ and other bad decisions which divert you from leading a full life.

At a less extreme level your instinctive response relates to how you process information.  For example, are you a ‘big picture’ person or someone who likes lots of detailed information?  A big picture person will not want to wade through a long detailed report, whereas a detail person will be anxious if they don’t have in depth information to enable them to make key decisions.  Someone who is fast-paced and likes lots of variety and minimal information will not appreciate a long, slow and detailed lecture which labours over facts.  A reserved, reflective and slower-paced person on the other hand will love this approach.

Your core communication style also extends to the form that you use to express yourself and how you prefer to have others communicate with you.  Forms of communication include numbers, shapes, sounds, written words, physical models, pictures and diagrams.  If you are getting information in the wrong ‘format’ then you are more likely to make a less informed decision or possibly no decision.  To find out your own preferred communication style visit www.financialdna.com and take the Communication DNA Profile.

Your natural behaviour also affects your core life motivations.  Conation is the term given to describe one’s natural tendency for taking action and affects our mental energy, instinctive behaviour, natural talents and drive.  Katherine Kolbe is a psychologist who has studied conation and the associated ‘hard wired’ personality traits.  This led her to identify four universal human instincts used in creative problem solving.  These instincts are not measurable but the observable acts derived from them can be identified and quantified.  This led to the development of the Kolbe A Index.  The instinctive behaviour traits are represented by four Kolbe Action Modes which cover the instinctive way that we a) gather and share information; b) arrange and design; c) deal with risk and uncertainty and d) handle space and tangibles.

In each of the action modes, the individual is scored (there is no good or bad score) to identify their instinctive propensity for different actions as either a) will not do; b) will do if required to or c) will do instinctively.

Kolbe’s contention is that if someone is required to carry out actions that are in an action mode for which they score ‘won’t do’, then this will cause frustration and stress in that person.  Equally the activity might be in the person’s ‘will do if required’ action mode and they can be competent at it but because it isn’t instinctive, it will require more effort and motivation than an activity which is instinctive.  In addition, in a stressful or striving situation, it is the instinctive behaviour which will be dominant.  Kolbe has developed this concept into what she calls ‘unique ability’.  If you only do work or activities which you are passionate about and that play to your unique ability, then you will be more fulfilled, experience less stress and have more success than if you try to do things that are not within your unique ability.

Over the many years that I have been consulting with private clients I have observed that most fulfilled, happy and financially successful people share one key characteristic - they really enjoy their work and hobbies.  As the famous philosopher Confucius said almost 2,500 years ago, ‘Choose a job you love, and you will never have to work a day in your life’.  One of the keys to living the life you really want is to know what you are instinctively good at and to deploy those talents accordingly.

We all have a unique risk profile which is determined by both our core and learned personality traits.  Knowing who you are in terms of your risk profile is probably one of the most important aspects of making committed life and financial decisions in building your financial plan.  The starting point with your financial plan will be to identify and quantify clear goals.  Once you know what you are trying to achieve you need to determine whether your goals are achievable by investing only in risk-free assets.  If the plan indicates that you require a higher return than that available from risk-free assets and you can’t find more resources or spend less then you will need to invest some of your wealth into risky investment assets.

By ‘risk’ we mean that there is a degree of uncertainty about what the actual return will be and that the value of the investment will vary up or down, sometimes extremely so.  However the payoff for that uncertainty is the probability that the overall return, particularly over the longer term, will be higher than that provided by the risk-free investment, thus allowing you to achieve your desired life goals.  Generally speaking, the higher the amount of risk, the higher the expected return.

The term we give to one’s ability to be able to withstand, financially, the effect of future returns being less favourable than were predicted or expected is ‘risk capacity’.  It thus represents a constraint on the maximum upside that you can expect from investing given your goals and resources.  In effect ‘risk capacity’ represents our need to take risks and to be able to live with the consequences of an adverse outcome.

A different, but very important measure of risk is ‘risk tolerance’.  This represents your emotional ability to cope with investment uncertainty or loss and is based on your personality traits arising from a combination of both your inherent (core) personality traits and also those that have evolved from your life experience, education and environment.  Inherent risk tolerance is very stable and doesn’t change much over time but will surface in times of stress or emotion.  Evolved risk tolerance can and does change over time and can easily be influenced by what is happening around you and the messages you receive.  My experience, which is borne out by behavioural finance research, is that an individual usually has higher overall investment risk tolerance when the stock market or property values are rising strongly, and they feel wealthy and optimistic.  It can also vary depending on the type of investment involved.


To gain a robust picture of your investment propensities, both inherent and evolved, risk tolerance must be measured.  Inherent risk, which affects not only the investor’s financial decisions but most decisions in life, is largely unchangeable.  However an investor’s evolved risk is likely to become higher as they gain education and experience but it does not measure many important areas of investment risk, e.g. how willing an investor is to take chances, commit to new products or venture into areas that are new to them.  The behavioural biases which flow from these inherent and evolved personality traits have important implications for investment and financial decisions.  Thankfully there are ways that investors can control these biases.

When investment and property markets and the economy were booming and before the global credit crunch hit, it is highly likely that your inherent risk tolerance traits were hidden.  In the good times we are usually overconfident in our expectation of future stockmarket returns and even more so about the returns we think that our own portfolio will generate.  We tend to think that the good times will continue.  This is similar to driving, in that we tend to think that we make better investment decisions than the average person.

But what happens when the stock market dives or there is some other big negative event (Iraq war, 9/11 etc.) and your investment portfolio shows a large loss?  The decision making patterns for many of us can change radically when good times turn to bad.  Our expectation for the future returns from the stockmarket and from our own portfolios is that they will continue to be poor.

As stated before, this happens because when we are under pressure our natural instinct instantaneously takes over and for many they have little control over it.  Financial losses are processed in the same area of the brain that responds to mortal danger.  This is why you often see a high degree of emotional decision-making which is not rational.

A survey of 1,000 investors carried out in the USA some years ago clearly demonstrated this point, as seen in Figure 2.  In June 1998 and February 2000 the stock market was at a high, having risen strongly.  In September 2001 the stockmarket was at an historic low after the technology boom fallout and the 9/11 terrorist attack.

Figure 2

Source: Kenneth L. Fisher and Meir Statman (2002), “Bubble Expectations,“
Journal of Wealth Management 5, no.2 (Autumn 2002): 17-22

In fact this approach is exactly the opposite of what investors should do because when markets have risen strongly, the future expected return is lower and their exposure to risky assets should be reduced in favour of defensive assets to bring the allocation back into line with their long term plan and vice versa.

Hindsight might be a wonderful thing but not when it comes to investment decisions.  We’ve all said to ourselves after a bad call, “How could I have been so stupid?”  Past events seem easy to predict after the event and by extension the future seems easy to predict.  This is caused by selective memory recall because we forget the thoughts and feelings that we had at the times that we made our ‘bad’ investment decisions.

Investing in what you know or are familiar with is another bias which provides a false sense of security by giving the impression of control.  Examples of this bias include concentrating wealth in a few well-known companies with which you are familiar or holding a ‘legacy’ share that you inherited.  The problem is that stock markets do not reward investors with risk premia (excess returns) for ‘loyalty’ or ‘familiarity’.  The market doesn’t know if your portfolio is undiversified – and it doesn’t care.

It is natural to want to avoid the source of pain, particularly if that pain is a large fall in the value of an investment.  This is why regret avoidance causes us to tell ourselves after a bad outcome, “I won’t make that mistake again!”  The problem is that while the loss was a bad outcome it wasn’t necessarily due to a bad investment decision.  Such counterfactual thoughts lead to regret avoidance and we say to ourselves, ‘If only I had not made the decision to buy X.’  You did buy X, so not buying it in the past is counterfactual.

Self-attribution bias is another key factor which impacts on our financial decision making.  We all make an average number of mistakes but when things go right we tell ourselves, ‘Look how smart I am’.  However, when things don’t work out we tell ourselves that we were just unlucky; ‘No one could have seen that coming’.  We credit success to self-possessed skills or inherent abilities and attribute failures to externalities that we could not know or control.

Extrapolation bias is closely linked to overconfidence bias discussed earlier, and is the process of assuming that historical returns, whether good or bad, will continue.  Or put another way we tend to binge on risky investments when we feel optimistic and investments are increasing in value and purge ourselves of risky investments when we feel bad and investments are falling in value.  Historical returns are based on old news and future returns are unknown.

News is a key factor in inducing detrimental investor behaviour.  More than ever before, news is freely and quickly available from the internet, 24-hour news television and daily email newsletters.  In the investment and financial context, for something to be classed as news it must be a report of recent events that was previously unknown information and has a specified influence or effect on individuals.  Professional financial planners call this news ‘noise’ because of its ability to influence extremely irrational behaviour in investors and elicit a range of emotional responses including gloom, fear, anxiety, envy and greed.

A point worth making about news is that the media report what has already happened and this has, by definition, already been factored into the prices of investments in quoted markets.  In addition the media don’t get paid more if investors make more money; they get paid more if they sell more newspapers, magazines or advertising.  If you don’t believe me then consider the following quote taken from a presentation given by Steve Forbes, the publisher of Forbes Magazine, to The Anderson School, University of California, Los Angeles in April 2003:
 
“You make more money selling advice than following it.  It’s one of the things we count on in the magazine business – along with the short memory of our readers.”

Steve Forbes

So what does this irrational investor mean in terms of investment returns?  In 2008, the S&P 500 Index returned -37.72% but the average US equity investor earned -41.63%.  From January 1989 through to December 2008 (20 years) the average US equity investor earned an annual return of 1.87%pa.  This represented an underperformance of the S&P 500 of 6.48%pa and an underperformance of US inflation of 1.02%pa.  There is no reason to suggest that UK investors are any different.

What these results tell us are that investors buy high and sell low.  The returns that they experience are more dependent on investor behaviour than fund performance.  Buy-and-hold investors typically earn higher returns over time than those who try to time the market.

You are more likely to make rational decisions if you have a high level of self awareness, financial education and experience, a secure relationship with money and a high level of ‘emotional intelligence’.  Even then the instinctive aspects of your core personality will still have an impact on your financial decisions.  With turbulent financial markets it is far more likely that your inherent risk tolerance will emerge and strongly influence your financial decisions.

“How I got here is pretty simple in my case.  It’s not IQ, I’m sure you’ll be glad to hear.  The big thing is rationality….  It gets into the habits and character and temperament, and behaving in a rational manner.”

Warren Buffet

At the end of the day you need to accept that there are some things that you can control and some things that you can’t and to have the wisdom to know the difference.  What you can’t control are picking winning shares, picking superior managers, timing investment markets or what the financial press says.  What you can control are investment expenses, diversifying your portfolio, minimising taxes and staying disciplined.  In that context, knowing your life purpose and financial personality is likely to give you the best chance of making good financial decisions. 

But I’ll leave the last word to respected US investment commentator Nick Murray:

“At the end of our investing lifetime, it won’t matter what your funds did, it’ll matter what you did.  And what you did will be a pure function of the quality of the advice you got – from one caring, competent adviser and not from any number of magazines.”


Jason Butler is a Chartered Financial Planner and Investment Manager at City based Bloomsbury Financial Planning.  He has twenty years’ experience in advising successful individuals and their families on wealth management strategies.