(September 2008) Volatile financial markets are not helpful to the economics of retirement. They can cause stress, worry or, depending on your risk tolerance, buying opportunities. Understanding and applying behavioural finance theories can not only mitigate much of the potential damage but can also actually improve the economics of retirement during these difficult times.
Behavioural finance is a rich academic study that kicks in where efficient market theory leaves off. The essence of this idea is straightforward — investors form ways of digesting information (“frames”) and thinking, particularly during periods of market volatility, that can lead them to savings and investment decisions that are not in their best interest. Understand these behaviours, identify them in clients, apply them to guide the client through stormy markets, and the client — and you — will be better off.
Investor myopia, loss aversion, overconfidence, self-control, good savings habits, mental accounting — these are all phrases from behavioural finance that are highly relevant to saving and investing for retirement. I’m sure every advisor in this country has encountered these ideas in some form or another, but let’s review each in turn.
Myopia is a medical term from the field of ophthalmology meaning that distant objects are blurred. Investor myopia effectively means that investors have a blurry vision about the future, the future being, in this case, retirement. Investor myopia about planning for retirement wasn’t discovered by the social scientists working on behavioural finance. They did, however, give us new insights by quantifying the problem through statistical surveys. Consistent with what I have heard personally from many advisors, the three most persistent areas, in order of increasing frequency, are
Of the three, figuring out clients’ retirement income and benefits is the easiest to resolve through a little research. Projecting what living costs might be in retirement reminds me of a theme I have written on in the past — the difficulty of envisioning a broad picture of what retirement will entail. Your clients don’t need to have a detailed mental picture of retirement in order to resolve this, but it does make the process much easier. If you can help your clients understand their projected living costs, income and benefits in retirement, this opens the door for you to resolve your clients’ main concern.
Loss aversion is the concern du jour in volatile markets. It is not hard to understand that investors hate to lose money. Behavioural finance has attempted to quantify just how badly they hate to lose. Specifically, the impact of a $100 loss is not experienced by the investor at the same magnitude as a $100 gain. Rather, it has been found that a $100 loss is experienced more at the magnitude of a $250 loss. Not surprisingly, viewing an investment loss at two and a half times that of an equivalent dollar gain can lead investors to biased investment-decision-making behaviours that effectively satisfy their aversion to loss at the expense of the longer-term investment gains. Not all clients can be persuaded to move away from loss aversion, but demonstrating that some investment losses are realistically an inevitable part of a profitable long-term investment plan will, hopefully, at least minimize the aversion among many clients.
The frequency of client overconfidence is likely to be pretty low in times of volatile markets. Yet, advisors who have been through a few market cycles will easily recognize that once markets are up for any extended period of time, clients tend to exhibit the same “irrational exuberance” exhibited by investors back in the Dutch tulip bulb investment bubble (early 1600s), the South Sea bubble (early 1700s), the Japanese property price bubble (early 1990s) and the Internet stock bubble (late 1990s). Investor sentiment is almost always the same during these periods: belief that the “good times” and above-normal returns will last forever, followed by feelings of shock and despair when they end. From the current market perspective, a return to such euphoric conditions may seem a long way off, but they will come. It is not easy to persuade clients to moderate their feelings, whether of euphoria or despair.
On a more encouraging note, many investors do exhibit self-control and good savings habits. Of course, the two go hand in hand. The former, the key to success in so many of life’s endeavours, is an integral part of saving and investing for retirement. The issue is simple, and one that economists have studied for decades: Do I spend more now and less later, or do I save more now and spend more later? Logically, the answer is clear: save (some) more now and spend more later. But for many clients, logic is not the main driver in these circumstances.
To quote from Hersh Shefrin’s book, “The needs of the present make themselves felt through emotion. Those needs have a strong voice and clamor for immediate attention. In contrast, the needs of the future have a much weaker voice, expressing themselves more through thought. Most people feel the urge to satisfy their immediate needs, but only think about satisfying their future needs.”
The general issue of self-control, and the decision to spend or save current income, is often influenced by the form in which a person receives his or her income and/or “one-time” financial gains such as employment-related bonuses or inheritances. The best way of saving out of income has been well known for decades: deduct savings at the source of the income, and the savings process becomes automatic, consistent and much less painful than if the client is required to make a conscious decision about each savings action.
One-time gains are a different matter. If it comes in a lump sum, there’s a larger chance that the money will be spent on current consumption. But the source also matters. People are less likely to spend an inheritance than a lump-sum employment-related payment and even less likely to spend a large part or all of a one-time payment that is received in periodic installments. What we are learning here is that the degree of self-control and good savings varies, depending on how the saving is carried out and the source of the money.
One of the processes illustrated in the previous paragraphs is mental accounting, i.e., how people treat financial gains differently depending on its source and/or frequency. Mental accounting is another aspect of behavioural finance that is of interest to financial advisors because it can have a powerful effect on the way clients think and behave. As has been said so often, the goal of saving and investing for retirement is to enter retirement with sufficient financial assets to accommodate the retirement that the client wants. But there is more to it. Every advisor knows a retired client who has the financial resources, but not the will, to spend. Mental accounting tells us that clients in retirement are much more likely to spend funds that come — or are perceived to come — from income rather than capital.
The thinking is understandable, and the practical issue is how to ensure that retired clients’ “income” is sufficiently large to ensure spending that will provide maximum satisfaction in retirement. One way is to structure a client’s investment in retirement to ensure a large amount of dividend income, which most people mentally account for as income. However, with low long-term interest rates (and the prospect that they are likely to remain low for the foreseeable future), some clients are going to require a fairly major shift in their thinking in order to make effective use of their capital assets. There are no obvious magic bullets for this challenge, but a client who has benefited from a solid long-term financial plan is more likely to heed advice to spend capital than one who has not.
Getting clients ready for retirement and keeping them financially happy in retirement are complex procedures. The process is not made any easier by the volatile markets that we have been seeing. Behavioural finance is not a panacea for volatile markets. But it is an extremely helpful part of the advisor’s tool box that is dedicated to ensuring that clients’ long-term outcomes are in their best interests.