What is Internal Rate of Return (IRR) ?
The Internal Rate of Return (IRR) is another very important metric that can be used to determine whether or not a company must invest its resources in a project. If the company does decide to invest its resources in all the projects then the IRR can help us understand what should be the priority of […]
Documents Required for Startup Financing
Setting up a startup company can require a lot of paperwork. It is common for startup founders to spend a lot of their time and effort putting these papers in order. It may seem like a mundane chore and even counterproductive. However, the reality is that the company needs to have all its legal documents […]
Savings and Loan Crisis in the United States (1980’s)
The United States banking industry and the economy in general was rocked by the Savings and Loans crisis in the 1980’s. The savings and loans associations had been an important part of the United States banking system. Hence, when one out of every four savings and loans in the US went under water, the nation […]
Shortcomings of the Bankruptcy Prediction Models
In the previous article, we have studied how bankruptcy prediction models have come a long way. It is true that they help investors make an educated guess when they put their money in a company. However, it is also important to understand that these methods are nowhere close to infallible. In fact, these models have […]
Anatomy of a Sports League Franchise Agreement
We have already discussed that sports leagues across the world follow the franchise model. Franchising is at the core of billion-dollar sports leagues which take place across the world. It is important to realize that franchising provides the legal and business framework which ensures coordination between the actions of different league participants. It is important […]
The traditional financial theory assumes that all investors are rational. Hence, they believe that all investors will reach the exact same conclusion with regard to investment decisions.
However, we see evidence of the opposite happening in the marketplace. Even if different people have the same information, they tend to process the information differently and come to different conclusions.
The difference in the way in which investors make decisions is taken into account in behavioral finance. Behavioral finance does not assume that all investors are the same.
It also does not assume that all investors are completely different from one another.
Instead, it believes that investors can be classified into a few categories. This is called psychographic profiling of investors.
In this article, we will have a look at what psychographic profiling is. We will also have a look at the Barnewall model, which is the most elementary psychographic model which has been used in the investment world.
Over the course of time, financial advisors have found that investors can be classified into certain types. This classification can be done based on certain tendencies, behaviors, or investment characteristics.
The entire concept is based on the idea that the past investment experience of an investor has a huge influence on the way in which they allocate assets.
When financial advisors are able to classify investors into different categories, they are able to understand and even predict their decision-making process.
Psychographic profiling is used both by the investors themselves as well as the agents who advise them to make investment decisions.
The Barnewall model was developed by Marilyn Barnewall in the year 1987. Since this model is more than three decades old, it is easily the oldest psychographic model.
The purpose of this model is to help financial advisors distinguish between the needs and aspirations of different clients that they have.
This model distinguishes investors into two simple types, viz. active investors and passive investors. This is the reason why this model is also referred to as Barenwall’s two-way model.
The advantage of the Barnewall model is that it is easy to classify the investors. It does not require any financial details. Instead, a simple, non-invasive review of the basic financial habits can help distinguish the investors.
Passive investors are the ones who have gained their wealth through passive means. They seldom get actively involved in the investment decision making process.
Generally, people who have fewer economic resources tend to become passive investors. This is because people who have fewer economic assets have a higher emotional need for security.
As a result, their risk tolerance is amongst the lowest.
Hence, they prefer to tread the known, tried, and tested safe investment path. Generally, this group only includes people such as corporate executives, small business owners, lawyers, journalists, bankers, etc.
Another category of passive investors is those who have inherited wealth and are living off the interest. In such cases also, safety is of paramount importance, and hence the passive investment route is selected.
The bottom line remains the same that people with fewer resources are most likely to become passive investors.
Active investors, on the other hand, are people who have gained their wealth by actively being involved in their own investment decisions. These investors are familiar with the concept of risk and are willing to take it.
Generally, they collect their own data, analyze it on their own, and need less advice while making a decision. They are more confident and display risk-seeking tendencies. This is because, firstly, they have more resources than the passive investor, and secondly, they have earned their money by taking such risks.
People in the active investor category are generally people who are directly or indirectly related to the financial markets and hence have a better understanding of how it works.
Active investors have an underlying belief that their higher involvement brings them more in control and hence ends up reducing the risk. This may not be the case in reality, but it continues to remain so in their perception.
Investment advisors are supposed to classify their clients and understand their behavior before recommending investments to them. Advisors are also supposed to counsel investors and help them overcome some behavioral flaws that they might have.
For instance, active investors believe that their research can reduce risks and help guarantee returns. It is the job of the advisor to communicate to the investor that this might not be the case.
The problem with Barnewall’s two-way model is that it is an oversimplification. Practitioners of behavioral finance believe that investors can be of many types.
Hence, slotting them into just two types is short-sighted, to say the least. This is the reason why the models which were developed after Barnewall’s two-factor model have more classifications of investor types.
Your email address will not be published. Required fields are marked *
