At first glance, retirement planning can seem quantifiable and formulaic.
You map your retirement lifestyle, create a diversified portfolio aligned with your income needs, plan for healthcare, build a cash flow plan, establish wealth protections, and so on.
But if retirement planning is conventional and cut and dry, what derails so many people from retiring happily?
If retirement planning could be as simple as checking the boxes, we would have several more people prepared for the next step. But here’s the thing: people aren’t numbers. And something that several pioneer financial experts discovered was that people aren’t all that rational, either.
What’s a tool that can help?
Today, we’ll explore what behavioral finance is and the influence it has on your retirement plan.
What is Behavioral Finance?
Behavioral finance is the study of how psychology impacts market outcomes. In the case of individual investors, it’s the study of how their personal emotions affect portfolio performance.
Analysts explore different biases, heuristics, and more to help explain common investor habits and ways to help them make better financial decisions.
Think about it like this; if we were robots, retirement planning would be a walk in the park. They could input data and make more accurate assumptions about how much to save and where in seconds!
But a robot can’t input the nuances of the human experience—savings goals, money habits, emotions, etc. As many experts in this field note, humans are hard-wired with varying emotions that are highly capable of overcoming logical thoughts and strategies.
A robot doesn’t have to worry about running out of money in retirement, stress about their health, figure out how to financially support adult kids, or struggle with a loss of identity and purpose. Those are issues an algorithm can’t solve.
So what behavioral pitfalls do investors need to be mindful of when investing?
Importance of Losses vs. Significance of Gains
Often referred to as “loss aversion,” this concept asserts that our minds tend to provide more weight and impact to losses than to equivalent gains.
Let’s look at a simple example.
- You’re walking down the street with $100 in your pocket. You bend down to tie your shoe and find a $100 bill on the ground. Sweet! You now have $200. A 100% return!
- But, say you have the same $100 in your pocket, and after running into the store for a quick snack, you find that you were parked in an illegal spot and have a $100 ticket. You’re livid! You now have $0. A 100% loss!
Most humans are far more upset about having $0 than happy about having $200.
Mathematically, they are identical. Emotionally, they are not even close.
This phenomenon is especially relevant in the world of investing. People are emotionally and financially invested in markets that can be highly volatile. As their portfolio increases, investors feel great and want to invest more. As markets decline in an equal fashion, they panic and want out, causing them to make irrational decisions like pulling money out of the market.
Many times, market volatility can be directly attributed to herd mentality. When one investor sells off all of their stock, another sees it happen and follows suit. It can feel like one big game of hot potato—no one wants to be the last person holding a valueless asset.
Being part of “the herd” is only natural. In our daily lives, we want to have friend groups and a community to engage with regularly. It serves us well to get along with people and not create friction that insights conflict. While socializing yourself into the world is beneficial in many ways, it does not help you make logical decisions with your investments.
What can you do to combat this urge?
Discover the time horizon and risk tolerance of your portfolio. You must understand when you need to start spending the money (time horizon) and how capable you are (financially and psychologically) to withstand market fluctuations (risk tolerance).
When you’re clear on your own financial goals and strategy, it’s much easier to avoid the pitfalls of your natural herd instincts. Gaining this clarity will help you avoid selling in a down market and getting overzealous in an upmarket.
In investing, and many other areas of life, humans tend to think they know more than they actually do. We tend to believe investment wins result from our knowledge, while any losses must have been attributed to bad luck or unpredictable market conditions.
In reality, trying to predict market returns in the short term is a multi-variable problem and nearly impossible to do consistently. Using the stock market as an example, how could you possibly know what is going to happen in the short term when so many elements impact public markets,
- A company’s intrinsic value
- Interest rates and inflation
- International and domestic government policy
- Investor behavior
- Media headlines
- Supply and demand
- Gross domestic product (GDP)
- Quarterly earnings reports.
This list is just a fraction of all the factors affecting public markets. The best investors are extraordinarily self-aware and do not pretend to have a crystal ball in front of them. They understand the value of long-term investing and don’t overestimate their personal knowledge.
Remember, just because public markets are easy to access doesn’t mean they are easy to understand.
Are You Ready To Invest Smarter?
Often, retirement plans go off the rails when an investor makes an emotional decision about their portfolio. This typically happens during a season of market volatility or after they have experienced an impactful life event that strains their finances. The key is to plan long-term and stick with it.
Sometimes, it’s helpful to try and quantify your composure as an investor, and it’s important to learn how your emotions might be playing a part in your decision-making as an investor.
A financial advisor can help to act as a sounding board or an accountability partner. Once you have a solid understanding of your financial circumstances and emotional tendencies, partnering with an advisor will help you keep the train on its tracks.
Schedule a call with us today!
The contents of this article are for general information and educational purposes and should not be construed as specific investment, financial planning, tax, accounting, or legal advice. Please consult with a professional advisor before taking any action based on the contents of this article. All investment and financial planning strategies involve risk of loss that you should be prepared to bear. We cannot guarantee any investment performance whatsoever, and past performance is not indicative of potential future returns.