Morningstar Advisor - October/November 2009 - 35

Active/Passive Questionnaire Question Response A Response B Have you earned the majority of your wealth in your lifetime? Have you risked your own capital in the creation of your wealth? Which is stronger: your tolerance for risk to build wealth or the desire to preserve wealth? Would you prefer to maintain a degree of control over your investments or prefer to delegate that responsibility to someone else? Do you have faith in your abilities as an investor? If you had to pick one of two portfolios, which would it be? Is your wealth goal intended to continue your current lifestyle or are you motivated to build wealth at the expense of current lifestyle? In your work or personal life, are you generally a “self-starter” in that you seek out what needs to be done and then do it, or do you normally take direction? Are you “income motivated,” or are you willing to put your capital at risk to build wealth? Do you believe in the concept of borrowing money to make money/operate a business, or do you prefer to limit the amount of debt you owe? Yes Yes Tolerance for risk Maintain control Yes 80% stocks/20% bonds Build wealth Self-starter Capital at risk Borrow money No No Preserve wealth Delegate No 40% stocks/60% bonds Continue current lifestyle Take direction Income motivated Limit debt one of four types. They are not absolutes. As we will see, dealing with irrational investor behavior is not an exact science. Rather, advisors should use behavioral investor types as guideposts as they develop strong relationships with clients. Each behavioral investor type is characterized by a risk tolerance level and a primary type of bias—either cognitive (driven by faulty reasoning) or emotional (driven by impulses and feelings). One of the most important concepts advisors should keep in mind is that the least-risk-tolerant type and the mostrisk-tolerant type are driven primarily by emotional biases. The two types in the middle of these two extremes are mainly affected by cognitive biases. Emotional clients tend to be more difficult clients to work with, and advisors who can recognize clients by type before making investment recommendations will be much better prepared to deal with irrational behavior. Step by Step Step 1: Interview Client and Identify Active or Passive Traits Most advisors begin the advisory process with a client interview, which consists mainly of a question-and-answer session intended to gain an understanding about clients’ objectives, constraints, and past investing practices. This interview should include assessing whether clients are active or passive investors. In other words, do clients put capital outside their portfolio at risk to build wealth? This distinction is important because passive investors tend toward one set of biases and active investors tend toward a different set of biases. The questions in the table above probe the active/passive nature of clients. A preponderance of “A” answers indicates an active investor; mostly “B” answers indicate a passive investor. Once advisors understand the process of assessing active and passive traits, a test like this may not be necessary. They will gain an intuitive feel for clients’ active and passive traits. Step 2: Administer Risk-Tolerance Questionnaire After classifying a client as active or passive, advisors should administer a traditional risk-tolerance questionnaire. Most readers have access to these questionnaires, so I will not provide one here. The expectation is that active investors will rank moderate to aggressive for risk tolerance and that passive investors will rank conservative to moderate for risk tolerance. Naturally, this will not always be the case. With an unexpected outcome, the advisor should put more weight on their risktolerance questionnaires. For example, if an investor is classified as active after Step 1 but he demonstrates conservative risk tolerance after Step 2, assume he is a passive investor. MorningstarAdvisor.com 35

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Morningstar Advisor - October/November 2009

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