Most of the people enrolled in your organization’s 401(k) retirement savings plan are not experienced investors. In fact, for most, the mere act of choosing which funds to include in their account can be a real challenge, if not downright intimidating. Along with that, the 24/7 presence of financial news on the internet can create anxiety for the retirement investor.
As a result, many of your plan’s participants are vulnerable to making some serious mistakes along their journey of investing for retirement.
The reality is markets, like most things in life, are cyclical in nature. There are periods when markets advance (bull markets), followed by periods of time when markets mostly drop or stay flat (bear markets). This is natural of course, but sometimes happen with little to no warning– just think of the 2008 or 2020 market shocks.
As a retirement plan sponsor, you have responsibility to provide education to your participants. But education can only do so much. Even if people are taught to expect the ups and downs, natural human emotions of fear and greed unfortunately drive our investing decisions. With enough repetition, education can sometimes overcome those emotions; but that doesn’t happen very often.
Want proof that retirement savers don’t always make the most sound investment decisions? According to a recent Dalbar Inc. study, “In 2018 the average investor underperformed the S&P 500 in both good times and bad, lagging behind the S&P by more than 100 basis points in two different months”. This study is not alone, either; many others have reported similar results.
But why do individual investors make such poor investment decisions in the first place?
Behavioral Finance: Identifying Common Culprits
You can chalk it up to a collection of emotional and cognitive biases. Emotional biases allow an investor’s judgment to be clouded by their emotions, such as the natural instinct to try to prevent a monetary loss or the tendency to over-value a personal possession.
Cognitive biases, on the other hand, cause investors to make poor decisions because of objective errors in their thinking or reasoning process. In other words, their brain plays tricks on them causing them to over-estimate their reasoning abilities.
It’s these biases that can cause individual investors to overreact to any number of “triggers,” such as market performance or economic news. Investors then end up being overly confident or overly cautious, trading too often too soon, or too little too late.
Here are a few of the common biases impacting retirement plan investors that you should be aware of:
Endowment Bias. We tend to place a greater value on an investment we currently own. This means once something comes into our possession, it’s hard to think about its value in a rational way. Our selling price then rises above what most buyers are willing to pay.
Recency Bias. We have a tendency to believe that what happened in the most recent past will continue to happen in the future. Thus, investors choose investments for their portfolio based on their most recent performance, a behavior also known as “chasing returns.”
The Disposition Effect. The disposition effect is the reluctance of an investor to sell losing investments, while at the same time prematurely selling off those investments that have made gains. Investors dislike losses and are willing to take risks in order to avoid experiencing them. Conversely, investors want to lock in gains, so they sell assets that have already earned them money– even if those same assets could potentially earn them even more in the future.
The Sunk-Cost Fallacy. The disposition effect is related to the sunk-cost fallacy. It occurs when investors refuse to cut their losses once an investment is made. Instead, they may actually invest additional time and money into the asset in the hope that they will eventually recoup their loss.
Herding Bias. In general, we tend to feel more comfortable following the crowd, assuming that the consensus opinion is the most appropriate one even when there is clear evidence indicating otherwise.
The Overconfidence Effect. We tend to overestimate our own abilities, thinking we know more than we actually do. But, the reality is most professionals have access to sophisticated tools and algorithms as well as historical data, and even they can’t always beat the market.
How Can You Help Plan Participants Avoid Costly Investment Mistakes?
Aside from regularly monitoring and reviewing the funds in your organization’s 401(k) plan so you can remove any under-performing investment options, the need for professional investment management and coaching is apparent given the results individual investors produce.
Education helps, of course and needs to be part of your offering. But in addition, this is where offering low-fee managed options, like model portfolios, can help you provide a better option. Target date funds are popular, but most may have high fees, so as always, take care in evaluating your options.
In summary, investor bias can be a real threat to the balances in your participant’s 401(k) accounts. But, by proactively offering safer investment options and a little guidance, you can help steer them and their money in the right direction.
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As potential risks rise, make sure your organization is prepared. Invest a few minutes today to make sure you are doing all you can to prevent problems in the future.