In our examples in Step 5 we learned about the need to identify different financial stages investors can find themselves in such as in the following scenarios:
- Our 30-year old needs to earn a 4.79% investment return each and every year, and can probably achieve this by investing in Guaranteed Investment Certificates (GICs).
- Our 50-year old needs an investment return of 16.30% each and every year, and they are not going to achieve this by investing in GICs. In order to achieve this rate of investment returns, our 50-year old will need to invest in very high-risk assets if they are going to have any chance of reaching their financial goal.
But what if our 30-year old finds GICs boring and really wants to invest all of his/her savings in the stock market? And what if our 50-year old is not a risk-taker, works hard for every dollar of savings, and really hates it when his/her investments drop in value? In both cases, their investing personalities are not compatible with their required average annual investment returns.
Example: For our 30-year old, his/her need for excitement and to not miss out on promised future stock market gains will lead them to take on unnecessary levels of risk with their savings and thereby possible wasting their greatest asset – time. The 50-year old, on the other hand, feels pressure to take on uncomfortable levels of risk in an attempt to achieve a financial goal that may be unreasonable. Rather than succumb to the pressure for ultra-high investment returns and investment risk, the 50-year old would be better advised to revisit his/her financial goals. In the long run, the 50-year old’s investing personality will eventually interfere with his/her selected portfolio design and asset mix. The first down turn in the stock market will cause him/her to retreat from the high-risk investments to safer investments.
So how do you determine your investing personality? There are so many different directions to approach this question. Providing an analysis of the different investing personalities is beyond the scope of our discussion. We simply wish to point out that each of us has a distinct investing personality that influences our investment decisions and how we manage changes in the value of our savings. We suggest that there are three main areas to consider in determining your investing personality as outlined below:
- Your past investment experience
- Your ability (emotional and financial) to accept decreases in the value of your savings
- Your view of money
Your past investment experience
The kind of investment experience a person has will help define their investment personality, as the following two examples illustrate:
- A novice investor will have limited investing experiences (good and bad) with which to base their analysis upon. They may not have experienced a full investment cycle and, therefore, do not know how they would react to seeing their savings decline in value by 20% or 35% or more. They may also not have experienced good investment cycles where they have watched their savings increase in value by 20% or 35% or more. They do not have a history of their behavior to guide them.
- A more experienced investor may have a historical reference when answering questions about their investing personality. They also have past mistakes and successes that can shape their investing personality.
Your ability to accept decreases in the value of your savings
When thinking about your investing personality, the basic approach is one that assesses your ability (emotional and financial) to accept decreases in the value of your savings. Analyzing your investing personality is not concerned with how you respond to your savings increasing in value. (Everyone pretty much responds the same to making money – we really enjoy it! It’s fun! It helps us to dream, to set new fun goals – goals beyond our basic needs.)
On the contrary, for the most part, an analysis of your investing personality is focused upon how you respond to losing money. And if you are investing outside guaranteed investments with a fixed maturity date, chances are that you will experience your savings declining in value at some point in your investing experience. There are numerous influences that dictate your ability to withstand losses to your savings. Our current lifestyle (sports and hobbies) often tell us a fair amount about our personalities and also about our investing personality, namely:
- Are you by nature a risk-taker? (Ever parachuted? Bungee-jumped? Raced cars?)
- When you read, do you read fiction? Factual biographies? Scientific journals? Do you read at all?
- Do you find it easy to save a few thousand dollars every month or do you struggle to pay your bills and have any extra money at the end of the month?
- Are you a disciplined person that makes a plan and sticks to it? Or are you someone that never plans anything, where whatever sounds like the most fun is what you do?
- Are you the type of person that always knows exactly how much you have in your bank account and what amount you owe on your credit card? Do you kind of know? Or are you clueless?
What do these questions have to do with your investing personality? Well, your answers will tell you a bit about your personality and how you view your savings and investments. For example:
- If you answered yes to question 1) and you have experienced one of the three mentioned activities, then there is a high probability that you will approach your savings and investments with a similar attitude. You will examine the risks and rewards. You will do your research. You will talk to friends and others that have experienced the activity and if the potential rewards outweigh your assessment of the potential risks, you will likely go for it.
- If, however, you answered no to question 1) and have never experienced any of the three mentioned activities, you might be inclined to approach your savings and investments with a similar risk-adverse attitude. You may do your own risk and reward assessment and determine that the rewards are just not sufficient to overcome the perceived risks. And more often than not your aversion to what you perceive as risk starts with an uncomfortable feeling in the pit of your stomach. It may not be rational, but it's just as important to your decision making process.
Remember: If you have limited investment experience to assist you in the analysis of your investing personality and/or are unsure how your personality should be defined, you are often best to start investing with baby steps. Specifically, begin your portfolio design with a very conservative allocation. It is much easier and less expensive to start with a small amount of your savings invested in the stock market and the majority invested in safe, secure investments. This is true in good and difficult investing cycles. For example, it is much easier to start with 10% invested in the stock market and increase to 15%, 20%, 30% as you gain experience and grasp a better understanding of your investing personality, than it is to start with 30% of your savings invested in the stock market only to find out that you are uncomfortable and want to reduce it to 20%, 15% or 10%.
Note: The most important aspects of your investing personality are never disclosed in good investment cycles, they always become screamingly evident in bad investment cycles. And reducing your stock market investments in a bad investment cycle is always more expensive and painful. So it is often better to begin conservative and take baby steps.
Your view of money
When defining your investing personality, try to think about how you feel about losing money. Do you accept the loss and move forward? Or does the lost money bother you for days and months later?
Note: For the past 20 years, Behavioural Finance has become a growing field of economic study. Behavioural Finance studies how humans respond to changes in value of their savings and the decisions they make as a result. To get a glimpse of this area of study, you can read a great article in the November 9, 1998 edition of Fortune magazine by Brian O’Reilly – “Why Johnny Can’t Invest.” The article explores a few of the more common personality traits that many of us share when it comes to our money and the financial decisions we make.
For the most part, however, investors all share a few common behavior traits, including the following:
Found Money – This behavioral concept helps to explain how we mentally account for money. Simply, we create mental categories for our money. Money that we have slowly saved over time is treated as much more important to us. Money that we find we mentally view with an “easy come, easy go attitude.” Money that we find as a result of a lottery win, gambling winnings, corporate bonuses, money found on the sidewalk and sometimes inheritance, we treat as found or free money. As a result of our mental accounting, we often treat, spend, and invest found money with less care, and as a result, found money more often than not tends to disappear.
Example: If you travel to LasVegas and you set yourself a $500.00 gambling limit, this is the amount you have mentally prepared yourself to lose. Now if you win $500.00 on your first day, you will often tell yourself that you are going to save your original $500.00 and only gamble with the $500.00 you won. After all, this is found money - easy money. But when the $500 in found money is gone, you will most likely go back to your original $500.00 and gamble with it. In doing so you will exceed your original $500.00 gambling limit. You will exceed this limit because you have a different mental approach to each group of $500.00.
If this sounds familiar, then there is a good chance that you will treat money made from investing in the stock market in the same way – as found money. Or you may mentally classify your savings into two or more categories – Capital, Income Earned, Capital Gains – and as a result, your investment decisions may be different depending upon which mental category you have slotted the money. However, one thing you should keep in mind is that money is money. It does not have different categories with some money classified as more or less valuable than other money.
Fear of Loss – Various studies have been conducted measuring how humans respond to investment losses and how we respond to investment gains. Our response to gains is predictable. We enjoy making money, especially if it is made the easy way (found). But the studies consistently find that we really hate losing money. In fact, it is estimated that as much as we enjoy making found money, we hate losing money twice as much. This loathing of investment losses influences our investment judgment. We tell ourselves that "an investment loss is not a loss until I sell the investment." Or the loss is only a paper loss, not a real loss. Our fear and loathing of losses also causes us to hold onto losing investments longer than we should. As a result of our fear of investment losses in general, investors are much better at buying investments than they are at selling investments.
Fear of Regret - This human fear inhibits our investment judgment because we fear making an investment decision today that tomorrow might appear to have been a stupid decision. This is one reason that investors very rarely ever tell you about the investments that lost money and only ever talk about the investments that turned out to be smart ones. Our fear of regret can paralyze us in indecisive inaction, like in the Uncle Dudley example in the “Why Johnny Can’t Invest” article mentioned above. It causes us to hold onto investments that really should be sold or it can keep us from investing our savings in anything other than a chequing account. This fear of regret reinforces that fact that investing involves making decisions about unknowable future outcomes.
Remember: For many of us, our investing personalities can only be clarified and defined after we have gained investment experience either on our own or with the help of an advisor. A clear definition of your investment personality evolves after gaining experience in good and bad investing markets. It does not result from the answers you give on some questionnaire.
Note: For a more detailed discussion of mental and behavioral influences on our investing personalities, see our discussion on Behavioural Finance.