Investor Types: Wealth Source and Situational Profiling

Investor Characteristics

• The decision-making process is influenced by a wide range of personal concerns and preferences
• Considering these factors leads to stronger, more enduring client relationships

Situational Profiling

• Situational profiling categorizes individual investors by their stage of life or economic situation
• It helps facilitate the discussion of investment risk by anticipating areas of potential concern or special importance to the investor
• Situational profiling can be based on the source of wealth, measure of wealth, and stage of life
• Use situational profiling with caution to avoid oversimplifying complex behavior

Source of Wealth

• An individual investor's attitude toward risk can be determined by how they accumulated it
• Entrepreneurs create wealth by taking on business and market risks
• Passive recipients are given their wealth
• Successful entrepreneurs may exhibit a higher level of risk tolerance
• "Self-made" investors are more familiar with risk-taking and have more confidence in their ability to recover from setbacks
• Self-made investors often have a strong sense of personal control over the risks that they assume
• Despite their willingness to take entrepreneurial risk, they can be reluctant to cede control to a third party or to accept investment volatility
• Passive recipients of wealth may be associated with reduced willingness to assume risk
• Investors who have inherited wealth, received a one-time payment, or accumulated savings during a secure employment have reduced willingness to accept risk
• Investors with passive wealth accumulation are assumed to have less experience with risk-taking

Measure of Wealth

• It is difficult to categorize investors based on portfolio size (net worth)
• Investors who perceive their holdings as small may demonstrate lower tolerance for portfolio volatility
• A portfolio whose returns do not easily support the investor's lifestyle might be considered small
• If the investor's ongoing needs are well covered, the portfolio might be considered large

Stage of Life

• Investment policy and risk tolerance are determined by one's progress from childhood to youth, adulthood, maturity, retirement, and eventually death
• A person's ability to accept risk should begin at a high level and gradually decline through their lifetime
• The willingness to assume risk should be driven largely by cash flow considerations
• Also consider life experiences, living conditions, starting point on the scale of wealth, and personal abilities and ambitions

Investment Policy Phases

• Foundation
• Accumulation
• Maintenance
• Distribution

Foundation Phase

• The individual is establishing the base from which wealth will be created
• This may include a marketable skill, establishment of business, or the acquisition of educational degrees and certifications
• The individual is usually young, with a long time horizon, which translates to an above-average tolerance for risk
• Risk tolerance should be above-average in the foundation stage if the individual has inherited wealth
• Lacking such wealth, it may be the period when an individual's investable assets are at their lowest and financial uncertainty is at its highest
• A young entrepreneur may have substantial expenses in establishing a business, resulting in a liquidity need that overrides all other considerations
• Marriage and the arrival of children may create a desire for more-rapid wealth accumulation that is not yet matched by either ability or willingness to assume risk
• Those who should theoretically be ready to assume risk, many are either unwilling or unable to do so

Accumulation Phase

• Earnings accelerate in the accumulation phase
• Returns accrue from the marketable skills and abilities acquired during the foundation period
• In the early years of the accumulation phase, income rises and investable assets begin to accumulate
• Expenses also rise during this period, through the establishment of family, purchase of homes, and care and education of children
• In the middle and later years of wealth accumulation, expenses typically begin to decline as children reach adulthood, educational needs are fulfilled, and home purchases are completed
• Income generally continues to rise as the individual reaches peak productivity
• If an individual's personal spending habits do not change, the gap between income and expenses may widen throughout the accumulation, allowing for an increase in savings
• The accumulation phase is characterized by increased risk tolerance, driven by their increasing wealth and a still long-term time horizon

Maintenance Phase

• The individual has moved into the later years of life and usually has retired from daily employment or the pressures of owning a business
• Focuses on maintaining the desired lifestyle and financial security
• Preserving accumulated wealth gains importance
• The growth of wealth may begin to decline
• Risk tolerance will also begin to decline
• Investors will typically reduce exposure to higher-volatility asset classes, such as common stocks, and increase exposure to lower-volatility investments, such as intermediate-term bonds
• Portfolio stability becomes increasingly important due to less time for individual to recover from poor investment results
• Must achieve a desired level of portfolio stability and maintain an exposure to risky assets sufficient to preserve the portfolio's purchasing power
• Investors who become too conservative too soon after retirement may reach an elderly age with assets that have suffered significant declines in purchasing power

Distribution Phase

• Accumulated wealth is transferred to other persons or entities
• For many, this phase begins when the individual is still reaping the benefits of the maintenance phase and retirement
• A conscious decision to begin transferring wealth
• Dealing with tax constraints becomes an important consideration in investment planning, as investors seek to maximize the after-tax value of assets transferred to others
• Planning for such transfers can begin much earlier
• The distribution phase should be a well-planned program executed over several years for individuals with substantial wealth
• Efficient wealth transfers take advantage of market conditions, tax laws, and various transfer mechanisms
• An individual may consider various transfer strategies, including establishing trusts or foundations for heirs or charities, making outright gifts of cash or assets, modifying the legal ownership structure of certain assets, and making advance provisions for care
• Although the progression from accumulation to distribution may be linear, it is not necessarily so
• Individuals in the accumulation phase may become dissatisfied with a career choice and return to the foundation phase
• A sudden illness or accident may move an individual unexpectedly to the distribution phase
• Personal circumstances are a driving force in how an individual responds to each cycle of life
• The foundation phase will be different for those who enter life with a base of inherited wealth than those who come from families of modest means
• The distribution phase can become increasingly complicated for the very wealthy but remain quite basic for those with little wealth

Additional Considerations

• Some investors never leave the accumulation phase because of obligations and lifestyle
• The stress of an adverse life experience may override all phases and never allow them to properly match their willingness and ability to assume risk in a suitable investment program
• Situational assessments allow investment advisors to quickly categorize potential clients and explore investment issues likely to be of greatest importance to them
• Investors seldom fall easily into just one category, and a dynamic relationship exists among the above considerations
• The value of situational paradigms lies more in their general insights into human behavior and less in their ability to fully interpret individual circumstances
• Investment advisors should emphasize the process of gathering and assessing relevant situational information rather than the specific category in which an individual investor may fall
• Advisors should recognize familiar patterns to better anticipate areas of potential concern and structure a discussion of portfolio policy in terms relevant to the client