A recent white paper titled “The Silent Value: Advice for the 21st Century” describes the challenges most of us face when attempting to make good financial decisions. Using the science of neuroeconomics (a combination of economics, neuroscience and psychology) the authors state that many of us hamstring ourselves by maintaining various bias’ and emotional connections which end up resulting in bad investment decision-making.
The white-paper shared the tendencies outlined below, explained via neuroeconomics, that lead to poor individual financial decisions. I have added suggestions on how to overcome these bias’ with your 401k participants.
1. Emotional decision-making
All of us get scared when the market is plummeting and become overconfident when the market is soaring. Often, at these market troughs and peaks, we make the wrong buy/sell decisions in our 401k plan accounts.
How to address: Understanding market cycles can often allay feelings of fear and greed when participants think about making investment decisions. Ask your advisor, in your employee education sessions, to emphasize a long-term view toward investing and sticking with a plan, especially during periods of high market volatility.
2. Loss aversion
You may be familiar with the study finding that we all fear loss about twice as much as we value a potential gain. Loss aversion causes 401k plan participants to adopt allocations in their accounts that are too conservative. The results are retirement plan balances that are not robust enough to support the longer retirements we all need to fund.
How to address: There are many effective risk assessment tools available. Make sure that your participants have access to at least one, and encourage them to use it. The better participants understand their ability to bear risk, the more comfortable they will be with their investment mix during market downturns.
3. Mental accounting
Many of us have a tendency to categorize our investment pools in a way that doesn’t make sense from a sound investment management standpoint. For example, you may have an IRA account, corporate retirement plan account, savings account and personal after-tax investment account. It’s likely that you never looked at all these pools of money as one investment account, which is necessary to balance risk and return appropriately.
How to address: Encourage your plan participants to seek help from the advisor attached to your retirement plan. If your advisor does not work with individuals, he/she can always recommend someone that does.
4. Selective attention
We tend to pay attention to things we are comfortable with and understand and dismiss things that seem foreign that we don’t understand. This results in not attaching an appropriate level of importance to events. When we make investment decisions in reaction to these events, they often end up being wrong.
How to address: Ask your advisor to outline the benefits of a long-term investment strategy. Have him/her go through the perils of market timing during your 401k education sessions.
5. Neuroeconomics and framing
The nightly news can make a small market downturn appear to be the end of the world. Investors place significant weight upon how events are framed and presented without taking the time to uncover the facts.
How to address: Ask your advisor to share some behaviors participants could follow during periods of market stress that encourage positive outcomes. For example, those participants prone to selling during market downturns should be discouraged from reviewing their accounts during these periods of time.
6. Familiarity bias
What is familiar is comfortable. Many experts believe our 401k accounts need to be diversified into commodities, real estate, and international equities. Most 401k plan investors tend to invest predominately in U.S. stocks and bonds, areas in which they feel comfortable. If 401k plan participants don’t diversify sufficiently, they will end up with account balances at retirement that are not large enough.
How to address: During your employee education sessions, your advisor should demonstrate the potential performance of different types of investment allocations. The goal is to illustrate the effects diversification has on reducing volatility and increasing long-term returns.
Make sure your investment adviser adjusts his/her next employee education presentation to include these latest neuroeconomics findings on individual investment decision-making.
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton has over 30 years of retirement plan consulting and administration experience and has provided consulting services to many Fortune 500 companies including: Aon Hewitt, Apple Inc., AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Car Company, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or firstname.lastname@example.org.
Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Advisory (RIA) firm providing investment advisory, fiduciary compliance, employee education, vendor management and plan design services to 401(k) plan sponsors. The firm currently has contracts in place to provide consulting services on more than $400 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or email@example.com or visit the firm’s website at: http://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.