Written by Christie Cheng
Behavioral finance is an area of study focused on how psychological influences can affect market outcomes. The retirement plan industry has really delved into this field because it helps advisors like RSG understand why people make certain financial choices, knowing that plan participants are NOT perfectly rational and self-controlled.
Historically, the market always rebounds. We presented this data at each of our RSG Covid-19 webinars in the first half of 2020. In 2008, it took five years to recover, and in 2015 the market took about 13 months to bounce. The data shows that even with the most severe downswings, over time, those who stay invested still see an annual 8% to 9% return on average. However, even with this information, we know from behavioral finance that people make very poor decisions when they panic. If they do sell, they’re going to be selling in a bad market and in essence doing the opposite of what you are supposed to do: locking in losses by selling low. When the markets rebound, they buy high.
Thankfully though, for the vast majority of RSG plan participants, they continued to get paychecks and hours through the crisis, so there was no real reason for them to stop their contributions into the plan in order to beef up cash flow especially since their expenses likely decreased from not being able to go on vacations or dine out. Despite remaining gainfully employed, many of our participants experienced much emotional turmoil with so much volatility and uncertainly in the world. It’s difficult, as an average retirement plan participant, to not feel a little panicked and fearful that their long term retirement savings was in jeopardy. During this time, it is important for us as financial advisors to help our participants stay the course and avoid irrational decision making. Some of the most common psychological drivers identified in behavioral finance as it relates to decision making are:
A participant’s desire to avoid losses in their retirement account is nearly twice as great as the joy felt from investment gains. In other words, participants may experience the pain of loss in their 401(k) plan to a greater extent than an equivalent positive return. Many advisors will tell you that their phones ring off the hook when the markets are falling yet when returns are up they rarely hear from their clients.
Acting on this fear of losing their retirement savings, participants may move their 401(k) allocations to less risky assets such as money market or stable value after a significant market drops which locks in their losses. Reinvestment (if that even occurs) into the market AFTER the recovery locks in high prices on the purchase side. It is essential to educate participants on market volatility and recovery concepts, dollar cost averaging and long term investment principles in years that aren’t as challenging as 2020.
Herding is a behavior which illustrates an investors’ tendency to follow the crowd. OR a consumer’s uncontrollable need to hoard toilet paper and bottled water during a pandemic. In the case of the current market crisis, some frightened participants may ignore or forget their long term strategies and retirement goals, time horizon and assessed risk tolerance and copy what other investors are doing and reallocate to cash instruments under the belief that safety is paramount. Here again, plan participants should be educated on maintaining a long-term investment plan based on their own time horizon and risk tolerance rather than following the crowd.
Confirmation bias is our tendency to search for, find, and interpret information that supports our opinion, while ignoring information that contradicts our beliefs. Many participants follow the news or seek advice but only from sources that tend to support their own opinion which of course does not represent the full picture. Helping participants maintain a long term strategic outlook by seeing all the objective historical data will help them avoid impulsive news driven bad decision making.
Overconfidence is a greed-driven bias, which happens when plan participants believe themselves to be better than average decision makers. If overconfident 401(k) participants overestimate their investment knowledge this may cause inappropriate risk taking and excessive trading. Thankfully we can say that very few RSG plan participants fall into this category. Many work directly with our Education Team and their own counsel to ensure that overexposure to risk is kept minimal especially when markets are unpredictable.
As the main contact for participant education, my team must do our best work in years when the markets are good and investor fear is minimal. With years such as 2020 emotions may cloud investor judgement and cause emotions and fear to drive decision making. Behavioral finance concepts help us create a foundation of knowledge for plan participants so that panic does not drive bad decisions. Better retirement outcomes may be achieved simply by doing nothing sometimes.