This document discusses the process of learning about clients in order to develop an effective investment policy and strategy. It outlines how investment advisors gather information through client interviews and questionnaires to understand a client's personal situation, financial situation, goals, and risk tolerance. Advisors need to be aware that clients may have difficulty expressing themselves or their true risk tolerance. Questionnaires provide standardized information but have limitations. Overall the process aims to develop a holistic understanding of the client to inform the investment policy statement and ensure their portfolio meets their needs and risk profile.

1. Planning
Execution
Feedback
Determine Investment Objectives and
Constraints.
Create an Investment Policy Statement.
Establish a Strategic Asset Allocation.
Select Securities.
Monitor the Markets and the Client.
Appraise the Portfolio’s Performance.
Re-balance The Portfolio.
The Investment Management Process

2. KNOW – YOUR – CLIENT!

3. Learning About Clients
Client Interviews:
Information gathering usually begins with a client interview
during which the investment advisor can learn about the
client’s life and dreams and can identify any issues or
problems.
The initial interview is also a good opportunity for the
advisor and client to share their philosophies about investing
to determine whether they will be able to work together
compatibly.
E.g., it ‘may not be’ appropriate for an aggressive investor
to have an advisor who is used to dealing with conservative
investors.

4. Client Interviews (contd)
The investment advisor may find that some clients have
difficulty expressing certain concepts in words.
E.g., while many individual investors know where they want
to be financially in 10, 20, or 30 years, most have a hard
time explaining how much risk they are willing to accept to
reach their goals.
To help obtain information that may not come out in an
interview, most investment advisors and firms use a
standardized or customized client questionnaire.
Learning About Clients

5. Client Questionnaires:
Can be multiple choice (clients select from a pre-determined
list of responses) or open-ended (the client must write down
the answer).
Some questionnaires focus on only one type of information
needed to develop a client’s investment policy, particularly
the client’s attitudes toward risk, while others gather a
broader range of information.
Risk questionnaires are popular tools because of the
difficulty clients have in expressing their tolerance for risk.
A scoring system is normally utilised to evaluate client
responses.
Learning About Clients

6. Questionnaires - Advantages
Questionnaires can be used to specify and prioritize
generic financial and lifestyle goals. - specifications about
client goals and to express which goals are more
important than others.
Questionnaires can be used to pinpoint areas for client
education. – questionnaires can uncover inconsistencies in a
client’s understanding
Family members can fill out additional questionnaires -
separate questionnaires can identify potential conflicts
between two or more family members.

7. Questionnaires - Disadvantages
Clients may not understand some of the questions or
may think they understand them when they do not.
Do not automatically assume your client is as
knowledgeable as you are about investing.
Clients may think they can predict how they will react
in certain instances, but real life situations may produce
entirely different reactions. – when an actual market
decline occurs, many investors are not as bold as they
formally thought.

8. Questionnaires - Disadvantages
Questionnaires are based on the assumption that
clients take a holistic approach to their assets. -
Questionnaires, apply a single set of questions to all
client accounts as if each investor viewed all assets in
the same way.

9. What Advisors Need to Know
Information needed for the Investment policy statement IPS,
is divided into four categories:
• Personal situation
• Financial situation
• Personal and financial goals
• Attitudes toward risk

10. Personal Situation
• Age
• Marital status (single, married, divorced, separated)
• Number of dependents
• Employment details (type of work, job stability)
• Educational background (certification, post-graduate)
• Investing experience (number of years, types of
securities)
• If married, all of the above information for the spouse
• If married, who makes the investment decisions

11. Financial Situation
• Amount of investable assets
• Annual income from all sources (other than investment
income)
• Annual savings target (or a list of annual expenses)
• Type of investment accounts (cash accounts, margin
accounts, registered retirement plans)
• Other investments (company pension, employee stock
options)
• Real estate (home, cottage)

12. Personal and Financial Goals
• Desired retirement age
• Desired retirement income
• Plans for major expenditures (vacation property, paying
for a child’s education, annual vacations)
• Gifting of assets (during lifetime or on death)

13. Attitudes Toward Risk
How the client defines
risk - (income
shortfall, delayed
retirement, less wealth)
• Client’s willingness
to take on risk
Attitude Behaviour
(Its really
a two-
way
street)

14. Investor Behaviour
Standard finance theory assumes that investors are:
• Are risk-averse
• Have rational expectations
• Manage their portfolios as a whole
Behavioral finance theory, on the other hand, suggests
that investors:
• Can be risk-averse or risk-seeking, depending on the
situation
• Have biased expectations
• Practice mental portfolio accounting

15. Risk Aversion versus Risk Seeking
In Standard Finance, investors are assumed to be risk-
averse, that is, given the choice between two investments
with identical expected returns, they will invest in the one
with the least amount of risk, as measured by the standard
deviation of returns. But in reality, clients faced with the
possibility of a loss, are often risk seeking rather than risk
averse.
In dealing with gains, people tend to be risk averse, but
when dealing with losses, tend to be risk seeking. This
asymmetric attitude toward risk can help explain why some
investors are unwilling to sell securities that have gone
down in value.

16. Rather than sell and realize the
losses, investors sometimes
hold on in the hope of a
recovery, even if there is a
chance that the loss could
become even bigger.
* Standard deviation : is a
statistical measure of risk that
measures the extent to which
returns differ from the
average or expected level of
return. (Pls commit to memory)
Risk Aversion versus Risk Seeking (1)

17. Biased Expectations
Standard finance assumes that investors have rational
expectations, that is, they all gather and act on information
in an efficient and unbiased way. i.e the “rational economic
human being” is a model of human economic behaviour
that hypothesizes that three principles rule
economic decisions made by individuals:
• Perfect rationality
• Perfect self-interest
• Perfect information

18. Behavioural finance commonly defined as the application
of psychology to understand human behaviour in finance or
investing. It claims that most people vastly overstate their
abilities. E.g., in a magazine study a group of adult men
were asked three questions:
• How would you rate your ability to get along with
others?
• How would you rate your ability as a leader?
• How would you rate your athletic ability?
Biased Expectations

19. All the men answered that they were in the top quartile in
terms of their ability to interact with others, and no fewer
than 25% said they were in the top 1%. A full 70% of the
men placed themselves in the top quartile of leadership
ability, and 60% answered that they were in the top
quartile as athletes.
Thus, people are can be a poor judge of their own abilities.
Investment advisors must keep this in mind when they
assess client responses to questions in interviews and on
questionnaires.
Overconfidence may cause investors to believe they are
more tolerant of risk than they really are.
Biased Expectations

20. Mental Accounting
Standard finance assumes that investors consider their
entire portfolio when they make decisions.
Behavioral finance, suggests that people compartmentalize
their portfolio into different accounts.
Mental accounting refers to the phenomenon whereby
people do not treat their assets as a single portfolio, but
keep track of them separately (Ref: earlier referenced
slides).
In practical terms, this means that an investor who made
N6,000 investing in one stock, but lost N5,000 investing in
another, is likely to dwell on the N5,000 loss, despite the
fact that the investor’s overall wealth increased by N1,000.

21. Investor Personality Types
Eight Investor Personality Types (IPTs) with three
personality dimensions:
• Idealism versus Pragmatism (I vs. P)
• Framing versus Integrating (F vs. N)
• Reflecting versus Realism (T vs. R)

22. Visual Depiction of Personality Dimensions
Idealism (I)
Framing (F)
Reflecting (T)
Pragmatism (P)
Realism (R)
Integrating (N)
Combinations of the three different personality dimensions
results in Eight Possible Investor Personality Types.
These are: IFT, IFR, INT, INR, PFT, PFR, PNT and PNR.

23. Idealism Versus Pragmatism (I Vs. P)
Clients that fall into the “idealist” end of the I vs. P
spectrum overestimate their investing abilities, display
excessive optimism about the capital markets and do not
seek out information that contradicts their views.
E.g, many investors continued buying technology stocks
even as they fell during the meltdown in 2000, eternally
optimistic that these stocks would make a comeback -
discerning patterns where none exist, and believing their
above-average market acumen gives them an exaggerated
degree of control over the outcomes of their investments.

24. Such clients are disinclined to thorough research and they
can fall prey to speculative market fads. Idealists are
susceptible to overconfidence, optimism, availability, self-
attribution, illusion of control, confirmation, recency and
representativeness biases.
On the other hand, Pragmatists, display a realistic grasp of
their own skills and limitations as investors - are not too
overconfident about the capital markets and demonstrate a
healthy dose of skepticism regarding their investing
abilities, understand that investing is an undertaking based
on probabilities, and research to confirm their beliefs.
Pragmatists are investors who are typically not susceptible
to the aforementioned biases.
Idealism Versus Pragmatism (I Vs. P)

25. Framing Versus Integrating (F Vs. N)
Framers: evaluate each of their investments individually
and do not consider how each investment fits into an overall
portfolio plan. They are rigid in their mental approach to
analyzing problems. Also they perceive their portfolio as
composed of ‘unique’ money, rather than a composite of
well-managed investments.
E.g., these clients typically have different allocations for
“retirement money”, “vacation money” and “university
savings”. This is not necessarily a bad thing, but advisors
need to watch for content overlap amongst allocations to
guard clients against over-concentrations in an asset class.

26. Framers also subconsciously “anchor” their estimates of
market or security price levels, clinging to arbitrary
purchase “points”, which leads to bias in future calculations.
But Integrators, are characterized by an ability to
contemplate broader contexts and externalities. Correctly
viewing their portfolios as systems whose components can
interact and balance one another out.
Integrators understand the correlations between various
financial instruments and structure their portfolios
accordingly, and are also flexible in their approach to the
market and security price levels.
Framing Versus Integrating (F Vs. N)

27. Framers may be
susceptible to the following
biases: anchoring,
conservatism, mental
accounting, framing and
ambiguity aversion.
Integrators are investors
who are typically not
susceptible to the
aforementioned biases.
Framing Versus Integrating (F Vs. N)

28. Reflecting Versus Realism (T Vs. R)
Reflectors have difficulty living with the consequences of
their decisions and have difficulty taking action to rectify
their behaviours - justifying and rationalizing incorrect
actions and hesitating to own up to decisions that have not
worked out beneficially.
They are also prone to decision paralysis because they
dread the sensation of regret should they miscalculate.
E.g., holding inherited securities – out of a sense of loyalty
to a deceased relative – which may not be a good fit in a
diversified portfolio in the current investment environment.

29. Realists, on the other hand, have less trouble coming to
terms with the consequences of their choices. They don’t
tend to scramble for excuses in order to justify incorrect
actions, and responsibility for their mistakes.
They don’t experience regret as acutely and, therefore,
don’t dread it ahead of time.
Reflectors may be susceptible to the following biases:
cognitive dissonance, loss aversion, endowment, self-
control, regret aversion, status quo and hindsight.
Realists are investors who are typically not susceptible to
the aforementioned biases.
Reflecting Versus Realism (T Vs. R)

30. Application Of Bias In Asset Allocation
High Level Of Wealth
(Adapt)
Emotional Biase
(Adapt)
Cognitive Biase
(Moderate)
Low Level Of Wealth
(moderate)
Moderate & Adapt
Moderate & Adapt
Adapt
Moderate
Source: Pompian, M. and Longo, J. “Incorporating Behavioral Finance Into Your Practice.” Journal of
Financial Planning, March 2005, 58–63.

31. Individual Clients may be better served by moving them up
or down the efficient frontier (a set of optimal portfolios),
adjusting risk and return levels depending upon the clients
behavioral tendencies i.e. client’s best practical allocation
– Micheal Pompian
A best practical allocation may slightly underperform over
the long term and have lower risk, but is an allocation that
the client can comfortably adhere to over the long run. Many
clients, in response to a market downturn, want to sell in a
panic.
Incorporation of Bias In Asset Allocation

32. Incorporation of Bias In Asset Allocation
2 principles for constructing a best practical allocation, in
light of client behavioral biases:
• Moderate biases in less-wealthy clients; adapt to biases
in wealthier ones - client outliving his assets constitutes a
far graver investment failure than his inability to
accumulate the greatest possible wealth.
• Moderate cognitive biases; adapt to emotional ones –
emotional biases originate from impulse or intuition
rather than conscious calculation, they are difficult to
rectify. Whilst, cognitive biases stem from faulty
reasoning, better information and advice – they can be
corrected.

33. Fortuna Favi et Fortus Ltd.,
:118 Old Ewu Road, Aviation Estate, Lagos,
:07032530965 www.ffavifortus.com info@ffavifortus.com