Retirement Watch

When investors behave irrationally

Behavioral finance provides insights to improve retirement-investing success

Sep 27, 2009 @ 12:01 am

By Greg Salsbury

The worst financial downturn in nearly a century has caused even the most rational investors to do funny things with their money, many of which may be very damaging to their retirement portfolios.

If our new environment has taught us anything, it is that “rational” investors don't always behave in logical ways, especially when it comes to money, and that the best financial advice in the world may be irrelevant if clients won't follow it.

Understanding why investors behave irrationally and make mistakes is the first step toward steering them in the right direction. What follows is a quick, three-part lesson in the behavioral aspects of spending and investing, to help you guide your clients to a secure retirement.

Mental accounting. Although the realities of the recession may have temporarily interrupted the free-spending ways of the boomer generation, the majority of investors are unaware of how certain expenditures can affect their retirement.

The reason for this blindness toward certain spending habits stems from the way investors view their assets. Consider clients who pay their monthly bills on time, pay off the balances on department store credit cards and keep a savings account for emergencies.

They claim to manage their debts well and even consider themselves frugal. Then they take out a home equity loan to put a swimming pool in the backyard. To their way of thinking, “That's different.”

In behavioral finance, this kind of thinking is known as mental accounting: People compartmentalize their spending and rationalize their habits for each compartment.

Prior to the meltdown, I would have argued that clients face potential risks by dividing their assets into pieces. Today, I think that we have to recognize this tendency among clients and adjust our recommendations accordingly.

Look for the path of least resistance to get your clients back on the road to recovery. If a client feels more comfortable with segmenting accounts into buckets, financial advisers can implement a range of strategies for the different buckets, devising approaches for both the short term and the long term.

Psychology of automation. In 1942, Beardsley Ruml, chairman of the New York Federal Reserve Bank, proposed that the federal government start collecting income taxes through a withholding, pay-as-you-go system. That was the dawn of the age of financial automation.

When it comes to building a retirement nest egg, I am a firm believer in the power of automation. The effectiveness of putting some financial decisions on autopilot is borne out by the behavioral-finance insights that the pain of paying taxes through automatic deductions is far less than writing out a single check at the end of the year.

Moreover, when we receive a tax refund — even when we know that it is our own money — we feel like we made out pretty well.

The same mentality applies to retirement plan contributions: The psychological pain of writing a single check to the plan is far greater than that of having a many small portions of our income automatically funneled into a 401(k) plan.

Consider encouraging your clients to employ financial automation to make retirement saving and planning a habit rather than a conscious act. For the millions of investors who have chosen to do nothing to save for retirement, automation may help them get started.

Managing expectations. The financial crisis will be a sore subject with investors for a long time. But it is an experience that you can use to gauge your clients' risk tolerance more accurately.

Advisers should ask clients: “What did you experience during this downturn, and how did it make you feel?”

For advisers, this is an opportunity to help protect clients from themselves. The downturn demonstrated all too clearly that risk tolerance isn't an abstract concept but one that has real-world consequences.

As investors move off the sidelines, “patience” will become the new watchword. The market drop happened rapidly, but the uphill climb will likely be slow and unsteady.

Managing expectations during the recovery, and not allowing in-vestors' optimism or pessimism to impede their long-term goals, will be a tremendous challenge for advisers.

More than ever, your clients are looking for your guidance in the unpredictable world of investing. Very often, that guidance may involve helping them manage their irrational behavior.

Greg Salsbury, executive vice president of Jackson National Life Distributors LLC, is the author of “Retirementology,” to be published early next year.

For archived columns, go to investmentnews.com/retirementwatch.

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