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How You Earned Your Money Plays a Big Role in Your Investing Mindset

We've discussed how our natural behaviors can play a big role in our investing decisions. Now, it turns out that the way you made your money could shed some light on the way make those decisions as well.

Michael Pompian's book, Behavioral Finance and Wealth Management, contained a section on psychographic models -- models designed to classify individuals according to certain characteristics, tendencies or behaviors. He explains that investors' experiences can play significant roles in their investment strategy and risk tolerance. The following explanation is based on work by Marilyn MacGruder Barnewall. It confirmed my own observations based on over 15 years of experience advising high-net-worth individuals.

Barnewall made the following distinction between "passive" and "active" investors:

  • "Passive investors" obtained their wealth passively -- via an inheritance or risking the capital of others (their client's or employer's). They tend to emphasize the need for security and have lower tolerances for risk.
  • "Active investors" earned their wealth by risking their capital, being deeply involved in the process of wealth creation. They tend to place less emphasis on the need for security and have a high tolerance for risk.
The very success of the active investors creates a behavioral problem. Because of their successes, they're not only confident of their skills, but they're also confident in their ability to tolerate, manage and control risks. These behavioral traits can lead to them to the mistake of failing to consider that the strategy to get rich -- work hard and take big risks, typically by owning a business -- is entirely different than the strategy to stay rich -- minimize risks, diversify the risks one takes and don't spend too much. The former is about wealth accumulation, the latter about wealth preservation. Those who have already achieved sufficient wealth to support a quality lifestyle can either focus on the preservation of capital by having a low allocation to risky assets like equities, or they can try to accumulate even more wealth by having a large allocation to risky assets.

While it's likely that a high allocation will result in greater wealth, you can be wrong. And you can be wrong for reasons entirely beyond your control. Because of their past successes, active investors often make the mistake of believing they have control. That causes them to underestimate downside risks. Events such as what occurred on September 11, 2001 should convince anyone that we only have limited control of outcomes. It's also important to understand that just because something hasn't happened in the past doesn't mean it can't or won't happen in the future. What is most important to remember is that the consequences of going from rich to poor are intolerable for most people.

One of the great investing tragedies is that many small fortunes have been created by starting out with large fortunes and taking risks that were unnecessary. And many small and large fortunes have been wiped out for the same reasons. If you're one of those who has already "won the game," and are still playing, ask yourself why. Are the risks really worth it? Would the extra wealth really change your life in any material way?

As you consider these questions, remember that research shows that even when we're highly confident, we overestimate our abilities. And remember to never make the mistake of treating what you might think of as unlikely as impossible.

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Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.

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