Understanding the Investor in You

By Michael Liersch, director of behavioral economics for Merrill Lynch Global Wealth Management
In an experiment conducted by Stanford University researchers, young participants viewed onscreen digital avatars of themselves. Some participants saw images of themselves at their current age, while others saw images of their future selves, aged via a process called immersive virtual reality. Participants who saw their future images allocated more than twice as much to their retirement accounts as participants who saw only youthful images.
This study is part of the growing field of behavioral finance, and can create a starting point for a collaborative conversation about your investing behavior. The idea is to make the investor’s appetite for risk and other behavioral traits a more integral part of the planning process.
Key to this process is understanding your Investment Personality, which takes into account your mindset and behavioral tendencies as an investor—including unknown biases and decision-making blind spots. Understanding this can allow you to invest in a way that’s more in line with your goals, risk tolerance, liquidity needs and time horizon. It may also help you avoid costly investing choices that can result when temporary market events cause shifts in your sentiment.
That’s not to say that emotions are something to avoid. On the contrary, you should embrace and work with your emotions. There are three key components of understanding your Investment Personality:
• Investment Mindset – your comfort with and willingness to take investment risk
• Investment Approach – the elements and solutions that can be included in an investment strategy to help you stay invested
• Investment Purpose – your reasons for investing and whom you’d like your investment to benefit
Different investors have different needs and preconceptions affected by many elements, including their assets, experience with the markets and age. Better understanding who you are as an investor can help you develop a financial strategy that better serves your needs.
Younger investors
Consider a young investor beginning to dabble in the markets: Having only known volatility and uncertainty in her investing lifetime, a natural distrust of the markets seems logical. In behavioral finance terms, this is what’s known as “recency bias,” or the belief that a short-term scenario reflects how a situation will progress. Ironically, “playing it safe” may turn out to be riskier in the long run for younger investors. By not investing, younger investors may be accepting a sure loss that’s equivalent to inflation.
A better understanding of one’s investment personality can help by allowing risk-averse investors to make decisions based on reality rather than perception. Equally important is having a more complete understanding of your goals and how to help achieve them. We often tend to think of risk in terms of losses, but true risk is not being able to achieve the goals we define for ourselves.
Young investors hesitant to wade into the markets can more clearly determine their relationship to risk by first considering their long-term objectives, and then devising an investment strategy. Are they more likely to have the assets they hope for in retirement by opting out of the markets? They may want to consider taking some market risk—albeit with some degree of protection.
Looking ahead to retirement
Investors who have watched the markets rise and fluctuate over the course of a lifetime have different concerns. Many baby boomers approaching retirement worry about outliving their finances, but there are steps they can take to reduce this risk, including delaying Social Security or purchasing an immediate annuity. Investors’ perceptions, however, often hinder long-term planning that may require committing a lump sum of money. Their perceived loss of control makes a rational decision seem counterintuitive.
Enhancing one’s awareness of how different strategies fit together to achieve personal goals can help. Income solutions like annuities should be viewed as insurance rather than investments, since they hedge longevity risk.A thoughtful approach to allocating assets helps you feel comfortable and assured in retirement but may reduce your upside potential.
Better understanding yourself as an investor isn’t necessarily meant to change your attitudes or behaviors. By recognizing your reactive traits and investing comfort level, as well as considering the purpose of your investments, this behavioral approach allows you to productively set your financial goals. Understanding why we make the choices we do is crucial to investors at every stage, for their present and future selves.
For more information, contact Merrill Lynch Financial Advisors Joseph Fehrle and William Sisco of the Egg Harbor Township, NJ office at 609-484-7103 or herman.j.fehrle@ml.com.
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