Emotion - The Retirement Investment Killer

It’s hard to rank which investment and planning mistake is more detrimental than others, but many of us in the advisor community would say emotion is certainly at or near the top of retirement killers. All humans have the same traits or biases that for thousands of years have served us very well. Instinctually when faced with our own survival and with very little thought our brains have created basic primal reactions. We may choose to stay and fight, we may run and we may hide.  If we are facing a bear, all of these possibilities have merit. If those same fight or flight instincts kick in with your investment portfolio, the bear will win just about every time.

Emotion has become such a major obstacle to success that financial advisors are investing more and more time into understanding “Behavioral Finance”. What causes you to make decisions that are detrimental to your financial health and how can we help coach you through these periods of anxiety and fear.

Let’s take a look at the more common emotional investing reactions:

• Recency Bias- I start with this one because it is the most common and the biggest detriment to successful investing. Recency Bias causes you to make investment decisions based on what is happening right now around the world. If things are bad, you think that they have to get worse. If there are challenges around the world, you assume a negative outcome for each one of them. You are facing the bear and running each and every time and in the world of successful investing, instead of preserving your life (assets), it instead was severely injured.

On the flip side, when things are going very well, you make the assumption that they can only get better. You call your advisor and wonder if you are being aggressive enough. You start to speculate and buy individual issues at very high valuations. In essence you start to do things you wouldn’t normally do because you feel you may be missing out on something. Fear and Greed, it’s the constant emotional repeatable cycle known as recency bias.

• Anchoring- Do you have a stock that is significantly down in value and you will wait forever to get even on it? This is known as anchoring. Now certainly you have to give any individual position a chance to flourish. We are not traders in retirement we are investors and as economic conditions change, we are sometimes forced to wait a little longer before a certain industry is back in favor. Anchoring involves an emotional attachment to a company whose fundamental characteristics have dramatically changed for the worse. Often there is little chance of recovery and in many cases these companies never return to the value you bought them at. We get attached to the name on the stock and never translate that the capital remaining would have a better chance to advance in something else.
• Loss Aversion- A second cousin to Anchoring is Loss Aversion. “Hey if I don’t sell it, I haven’t really lost anything”. “It’s only a paper loss right?” Even the best professional investors are going to be wrong a certain percentage of the time. It is simply not possible to get every pick right as sectors are constantly rotating, economic conditions change and you have no way of knowing what news or fundamental changes will occur in the future with the company you selected. You must have a sell discipline if you are going to own especially individual issues as you are adding potentially more risk to your retirement portfolio. 
• Overconfidence Bias- This emotional mistake means you often trade and manage your portfolio on a stock by stock basis, assuming you have the ability to beat the market. Even professionals realize that over longer periods of time it is extremely difficult to beat the market and for retirees, should never be a goal. While we don’t certainly want to underperform, market performance is all that we need to maintain our retirement lifestyle. If you are trading more because you need more, retirement may have started too soon. Because trading your own portfolio often leads to attempting to market time, the overwhelming majority of individual investors will drastically underperform the market over time. More on this in a second.

You may be saying at home, wait a minute! My friend Joe got out of the market four months before the crash of 2008 and it saved his whole retirement! This is one we hear all the time as it seems like everyone’s friends crystal balls work better than those of the entire financial community. In my earlier life, I was a pit boss in an Atlantic City casino. For years we were privy to many a conversation between customers all trying to one up each other. Most if not all the players would regale about how they were beating the casino over time, had come up with a system, or figured out a way to make extra money on a regular basis. Sound familiar? Insert equity markets in place of casino. The reality is virtually no one was beating our casino over time and the same holds true for all the people allegedly missing the crash. Don’t get me wrong, I have no doubt some people got out beforehand. But those same people are constantly in and out, trying to find the most opportune times to invest and history tells us that leads to nothing but underperformance. Trying to make two correct decisions, getting out at the right time and getting back in simply doesn’t work!

To demonstrate the massive underperformance of overconfidence bias and market timing create, we need look no further than the Dalbar, Inc. study of investor behavior. The study involved mutual fund purchases and sells but illustrates not only Overconfidence Bias but Recency Bias as well. The study is called the Quantitative Analysis of Investor Behavior and it began in 1994 with statistics for this article run through year-end 2012 update. Dalbar concluded that investors were not participating in long-term mutual fund returns because of frequent switching among funds. It was shown that many investors were chasing hot returns in order to get better returns…..but just the opposite occurred.

The study is updated each year and utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. These behaviors are then used to simulate the “average investor.” Dalbar has found that the hopping from fund to fund in order to find something better actually decreased investor returns. Investors were found to “hop” for a variety of reasons, one of which was better performance. That performance often was derived from various financial publications and their “top funds to own now” editions. The other most common reason for hopping was panic from short-term losses and get out of the market for an extended period of time.

Here are the actual numbers from the 2012 update, which are the most recent results released. It includes performance over the 20-year period extending from January 1, 1991 through December 31st, 2011. You may have thought investors switching funds and getting out of the market would have enhanced their returns considering the tech crash, which spanned from 2000 through 2002 and the financial meltdown of 2008……you would be incorrect.

1. 1.       In the 20 year period, year-end 2011, equity mutual fund investors had average annual returns of only +3.49% while the S&P 500 index averaged +7.81%.
2. 2.       Fixed income investors had an average return of +0.94% versus the Barclays Aggregate Bond Index averaging +6.50%
3. 3.       If we break it down into periods, Equity and Bond investors underperformed in the 1, 3, 5 and 10-year periods as well.

Bottom line, get your investments out of your own hands and don’t let your emotions, the greed part anyway allow you to fall prey to some salesman who has a secret strategy that beats the market over the long term. It a big game! Although no strategy ensures success or protects against loss there are many strategies available and multiple ways to address risk. They may include downside strategists, sector and/or country rotation, inclusion of negatively correlated investments and many, many, many more techniques! This may help reduce at least some of the investor-inflicted wounds, which the Dalbar study continues to illustrate as a major cause of investment underperformance.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment (s) may be appropriate for you, consult your financial advisor prior to investing.