Commentary: A recent white paper titled
The white-paper shared the neuroeconomic tendencies outlined below that lead to poor individual financial decisions. I have added suggestions on how to overcome these biases with your 401(k) 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 401(k) 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 adviser, 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.
Also see:
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 401(k) 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 adviser attached to your retirement plan. If your adviser does not work with individuals, he/she can always recommend someone that does.
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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 adviser to outline the benefits of a long-term investment strategy. Have him/her go through the perils of market timing during your 401(k) education sessions.
5. 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 adviser 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.
Also see:
6. Familiarity bias. What is familiar is comfortable. Many experts believe our 401(k) accounts need to be diversified into commodities, real estate and international equities. Most 401(k) plan investors tend to invest predominately in U.S. stocks and bonds, areas in which they feel comfortable. If 401(k) 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 adviser 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 findings on individual investment decision-making.
Robert C. Lawton, AIF, CRPS is President of