Pompian, Behavioral Finance and Investor Types

We know from the extensive literature on behavioral finance that investors suffer from cognitive and emotional biases that can undermine wise decision-making. Moreover, Michael J. Pompian argues in Behavioral Finance and Investor Types: Managing Behavior to Make Better Investment Decisions (Wiley, 2012), investors are also constrained by their personality types. Combining insights from behavioral finance and personality theory, the author offers guidelines to help self-reflective individual investors and, perhaps more aptly, to help investment advisors deal with their clients.

The author identifies four primary behavioral investor types: preserver, follower, independent, and accumulator. Let’s say you’re an independent investor, that is, you are “engaged in the investment process and opinionated on investment decisions.” You’re likely to pursue an active investing style, with an above average risk tolerance (though not as high as aggressive investors). You’re also prone to cognitive biases such as confirmation bias, availability bias, self-attribution bias, conservatism bias, and representative bias. Pompian provides diagnostic quizzes to help identify particular biases.

After ascertaining that you’re an independent investor and that you’re likely to fall victim to particular biases, what would a financial advisor do with this information? “Independents can be difficult clients to advise due to their independent mindset, but they are usually grounded enough to listen to sound advice when it is presented in a way that respects their independent views. … A good approach is to have regular educational discussions during client meetings. … Because Independent biases are mainly cognitive, education on the benefits of portfolio diversification and sticking to a long-term plan is usually the best course of action.” (p. 133)

Pompian’s book is simple in its approach but is based on solid research. As long as financial advisors have clients who are willing to fill out the appropriate questionnaires and take little quizzes (would that both the questionnaires and the quizzes were more sophisticated and less obvious), they should be able to offer tailored advice goes beyond a client’s age and financial situation.