Fear of loss and greed for gains aren't new ideas in the world of investing. In fact, they probably date back to humanity's ability to think, worry and reason.
But the fact that these behaviors accelerate when investors retire has financial services firms working overtime to find ways around investors' emotions. After all, with millions of baby boomers marching into retirement, getting it right is critical. The good news is that the mounting body of behavioral economics research is yielding a bonanza of practical insights and solutions that may help advisors keep clients from doing the most deleterious thing at the very worst possible time-as they enter retirement.
"What we're trying to find out is what are the biases of human beings on every decision involving personal finance," says John Cammack, director of third-party distribution at T. Rowe Price in Baltimore. "What we're learning is that in general, investors are inclined to do the wrong thing with money in retirement. The major tendency is to become too conservative. Something goes on when people give up the ability to earn income."
To garner greater insight into investor behavior, companies and academics are using behavioral economics, a discipline within the field of finance that looks to psychology for the explanations behind investors' decision-making. Simply put, by understanding what makes investors behave erratically, an expert can help them achieve great investment success.
One thing is certain, researchers are learning that when paychecks stop, the tendency to become ultraconservative with investments sets in. In his best seller Predictably Irrational (Harper, 2008), MIT professor Dan Ariely writes that expectations, emotions and social norms guide investors more than reason. And it is noteworthy, he says, that we make the same mistakes again and again.
How does this play out for retirees? They tend to overvalue what they have in their retirement nest eggs, something Ariely calls the "endowment effect." The upshot is that they focus more on what they can lose than what they can gain.
But on the other hand, they may pursue more costly investment strategies to avoid losses. One example of loss aversion in action: The phenomenon that occurs when investors retire and move their portfolio into CDs, money-market funds and short-term U.S. bonds. By earning just 1.5%, they ensure that they won't lose principal. But at what cost? A portfolio earning just 1.5% is actually costing an investor who faces a 4% annual inflation rate, plus taxes, all the while shortening the life span of their nest egg.
More than 70% of retiring investors at T. Rowe Price move into money markets or stable value funds, according to surveys and focus group research the fund company has conducted. "What we hear over and over from them is: Protect principal, invest more conservatively," says Mark Mitchell, vice president and director of marketing at the firm. "What drives retirees is blind faith. They think, 'Oh, it will work out. I'll spend less. I have some home equity.' But do they? They believe that because things have worked out before while they were still fully employed, they'll work out now. They forget that the safety nets can really start to diminish."
Can investors and advisors counteract these emotional and irrational behaviors, especially the risk and loss aversion that sets in at retirement? Ariely says the answer is yes and that once we understand how and when investors make erroneous decisions, financial services firms and advisors can work to stem the irrationality. The best bets are counseling, visual tools and technology, which, when used properly, can overcome what are, as Ariely calls them, investors' inherent shortcomings.
"Advisors need to do a lot more coaching to enable the customer to do the right thing," Cammack says. "We have to reinforce the importance of having money in the equity markets. When retiring investors understand longevity risk, they begin to understand that they have to grow their money to ensure that they don't outlive it."