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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.
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