Another concern is whether investors are disciplined enough to stay the course with the investment strategy in order to earn the underlying index market returns. Studies on retirement spending from investment portfolios typically assume that retirees are rational investors who rebalance right on schedule each year to their rather aggressive stock allocations. They never panic and sell their stocks after a market downturn. For many retirees, this may not describe their reality. The behavior gap refers to the concept that investor behavior may cause real individuals to underperform relative to index market returns.
The behavior gap has been estimated, and there is somewhat of a consensus, that individual investors do underperform the overall markets by a couple percentage points per year. For instance, Vanguard’s study of Advisor’s Alpha identifies the most important factor explaining investor underperformance as a lack of behavioral coaching to help investors stay the course and stick with their plans. They estimate that having the wherewithal to stay the course in times of market stress could add 1.5 percent of additional annualized returns to the portfolios of typical investors. In other words, without behavioral coaching, the typical investor could expect to underperform the markets by 1.5 percent per year due to poor decision-making.
Evolution has designed us not to be effective long-term investors, but rather to seek to avoid short-term dangers. The fields of behavioral finance and behavioral economics have uncovered various biases humans have that are helpful for day-to-day survival, but somewhat maladaptive for long-term investing. A significant body of research is dedicated to detailing these investor behaviors. These are some of the most common behaviors that lead to poor financial outcomes.
Availability Bias/Recency Effect: Using recent or current market behavior to predict future market behavior
The most recent events are always freshest in our minds, and we tend to extrapolate recent events into the future, expecting more of the same. We tend to make long-term decisions based on short-term performance. Large recent market gains lead us to be optimistic about our chances, while market losses have the opposite effect. It takes discipline to overcome these natural tendencies to simplify matters into what can most easily be recalled.
Loss Aversion: Fearing a loss more than you want to make gains
As human beings, we tend to feel that the pain of experiencing a loss is greater than the joy felt by an equivalent gain. This leads to emotional decision-making for financial decisions, as we feel worse about losing relative to a starting point than a symmetric gain from the same starting point. With evolution, this was probably a useful survival tool, but it does not help with investing. It can lead to the avoidance of stocks that require accepting greater short-term volatility (and paper losses) in the effort to achieve upside growth potential and long-term gains. Not recognizing this predisposition can cause people to misjudge their tolerance for risk, making them more likely to bail on their financial plan.
Overconfidence: Believing you know more than other investors
While investment research increasingly points to the difficulty of beating the market—especially after fees, trading costs, and taxes are taken into account—it is natural to believe we know more than everyone else. This is the “Lake Wobegon effect” in practice. As Garrison Keillor relates in A Prairie Home Companion, Lake Wobegon is a place “where all the children are above average.” It is all too easy for investors to fall into this kind of thinking. We tend to be too confident in our decision-making around random and uncertain events. This may lead to too much trading and less-than-prudent amounts of diversification.
Hindsight Bias: Thinking you can predict market behavior because you believe you know why past market behavior occurred
In hindsight, market losses may seem to have an obvious or intuitive explanation. We seek to construct a narrative with cause and coherence, such that memories about past events suddenly become straightforward and predictable. This bias can feed into our overconfidence and cause us to believe we will be able to anticipate such market changes the next time around.
Survivorship Bias: Underestimating the risk by ignoring the failed companies
We may underestimate the degree of market risk if we look only at companies still operating today. This misses out on the lessons of many failed companies no longer on the investment radar. It is like thinking a marathon would be easy to run because you watched a bunch of people cross the finish line. You’re ignoring all the people who gave up before reaching the end. This can also feed overconfidence.
Herd Mentality: Judging your own success or failure based on that of others
Sometimes the herd mentality can be rationalized. You don’t want to miss out on being rich when everyone else is rich, and perhaps being poor is not so bad when everyone else is also poor. But for a long-term investor, following the herd rarely makes sense. It leads to joining the same greed and fear cycle that drives the average investor to buy after markets have already gained and to sell after markets have already dropped.
Ambiguity Aversion: Disliking uncertainty leads to betting on what is known
This behavior drives investors to bet more on what they know than on what they do not know. It has been offered as an explanation for the equity premium puzzle. Stocks have outperformed bonds consistently and by relatively wide margins over time, more so than can be explained by their risks for long-term investors. It may be because investors prefer the short-term safety of bonds, not recognizing the greater long-term growth potential of stocks.
Framing: Reacting differently based on whether the same outcome is presented as a loss or a gain
People’s decisions can also be based on how a problem is framed, even if the underlying problem is the same. For instance, asking someone the probability they will live to eighty-five should lead to an answer that is 100 percent less than the probability that they will die by age eighty-five. But framing the problem in terms of dying by eighty-five leads to much less optimism than framing the problem as surviving to eighty-five.
Home Bias and Company Stock: Preferring what is most familiar
Our brains are more comfortable with the familiar. At the extreme, this can lead to disproportionate ownership in one’s own company stock, or more simply a bias toward domestic assets over international assets. Both actions lead to a less diversified portfolio and greater exposure to risks that could have been diversified away.
Behavioral Cycle of Investing: Buying high and selling low
Falling markets can be stress-inducing events as we witness our wealth evaporating at a quick pace. This stress can trigger short-term fight-or-flight mechanisms in our behavior that may have helped to avoid day-to-day dangers on an evolutionary basis, but which are not adapted toward sustaining long-term investment success. Market volatility can lead to bad decision-making and to jettisoning well-considered plans. Short-term stress reactions will often involve deviating from the financial plan and selling stocks out of fears for further portfolio losses when historical evidence overwhelmingly suggests it to be wise to stay the course with the plan to build greater long-term wealth. Once a well thought out investment plan is in place, it is frequently better to do nothing in the face of stressful market situations. But this counters human evolution about the way to respond to such situations.
In times of market stress, it is important for retirees to stick with their financial plans and the asset allocation that matches their tolerance for market volatility. Most research about retirement spending from an investment portfolio assumes that investors behave in this rational way. Unfortunately, investors in financial markets tend to do the opposite of what happens in most other markets: they buy more when prices are high and sell when prices are low. This causes returns to drag behind what a “buy, hold, and rebalance” investor could have earned. To the extent that households fall victim to bad behaviors, the net returns and sustainable spending rates from their investments will be less than otherwise possible.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.
