– Editor's note: This article is the fourth in a series by CLS Investments CEO Ryan Beach covering his firm's research on advisor-client relationships. Read the first installment here.
Now that we've considered how cognition and biodata play their respective roles influencing investors, it's time to look at the third and perhaps most challenging behavioral element — individual factors. To date, most of the work done in the arena of behavioral investing has centered on observable characteristics (biodata) and behaviors themselves (cognitive biases).
However, the predictive ability of these metrics is limited by their observable nature. The field of behavioral finance is currently missing an understanding of the internal, core characteristics of people who interact with these observable characteristics, to better predict how people make decisions about finances and investments. These characteristics are best described as personality traits, emotional tendencies or individual motivators.
Personality
The two primary personality models that have been investigated in behavioral finance are the Big Five personality traits and, more recently, the Myers-Briggs model. The Big Five personality traits are:
- Openness
- Agreeableness
- Conscientiousness
- Extraversion
- Neuroticism
The Big Five is one of the most widely used personality models across various disciplines and has shown some predictive power in investment performance, such as:
- Extroverted individuals are more likely to make fewer investment trades than introverts, but they tend to have a higher propensity for short-term and risky investments.
- People who score high in "openness to experience" are more likely to choose long-term investments than other investors are, and are also more open to riskier investments.
- Investors who experience loss and are high on agreeableness or low on conscientiousness tend to have the more positive reactions and coping styles with financial loss.
- Neuroticism, which is characterized by heightened emotional responses, anxiety and fixation tendencies, was found to be related to risk-taking, in addition to greater discomfort and dissatisfaction with risky decisions.
The Meyers-Briggs model, in contrast, considers four dimensions of personality:
- Extraversion
- Information processing (sensing vs. intuitive)
- Decision style (thinking vs. feeling)
- Preference for structure (judging vs. perceiving)
This model is extremely popular in many industries because it categorizes people into types based on their approach to different situations. Research applying Meyers-Briggs to financial decision making has shown that:
- Individuals with a thinking decision style (preference for objective decisions and fairness) are more risk tolerant than individuals with a feeling decision style (preference for subjective decisions and congruence).
- Those who are more sensing in their information processing (concrete thinkers) are more equipped to tolerate higher potentials for gains or losses than intuitive processors (abstract thinkers) are.
- Intuitive or abstract thinkers tend to be risk takers.
In addition to these two main personality models, several other personality traits have been studied. But overall, the results of the limited personality research to date are inconclusive and incomprehensive, even though there is substantial evidence that individual characteristics are predictive and important in financial decision-making.
Motivation and Emotion
One of the most compelling motivational theories that applies to financial decision making is regulatory focus, which as a construct, measures the promotion- vs. prevention-oriented nature of an individual.
Typically, these orientations have both a stable, individual-level component, as well as a domain-specific component. When people are promotion-oriented, it indicates they are motivated to seek the potential for high gains.
Conversely, when people are prevention-oriented, it indicates they are motivated by avoiding losses. There is some evidence that these motivational tendencies not only predict how people will make decisions in the financial sector, but also differentiate between the types of investments people will pursue.
