Recent behavioral finance studies have shown that most participants invest too conservatively. As a result, most are not on the road to building an account balance large enough to fund the sort of retirement they expect. How can employers help plan participants become better investors? Helping employees understand and overcome ambiguity is a good first step.
With regard to investing, ambiguity is represented by potential outcomes that can't be quantified or measured. Typically, when assessing risk for investment decision-making purposes, outcomes are expressed in terms of their probability of occurrence. Ambiguous outcomes are non-quantifiable.
Ambiguity is an uninsurable risk. We can purchase insurance to help deal with loss from most risky events. We can lay-off risk, spread risk and avoid risky situations. Although ambiguity is a form of risk, there is no way to insure against it.
The potential of the eurozone crumbling is a good example of ambiguity in the markets today. There are too many factors at play (countries, economies, political environments, cultures, etc.) for outcomes to be calculated with any degree of certainty. What would the end of the eurozone mean to investments in participant 401(k) plan accounts? No one knows for sure, nor can anyone make an educated guess.
Since the impact ambiguous events could have on participant investments is unknown, ambiguity tends to lead participants to become more conservative investors. Participants end up favoring fixed income or safer allocations in their 401(k) plan accounts, rather than equities. The result is a lower account balance than needed to meet retirement goals.
The key to overcoming ambiguity is for participants to adopt a risk appropriate asset allocation and stick to it. Ambiguous events come and go. If participants let the fear of ambiguous outcomes affect their decision-making, they will never implement an allocation strategy that is aggressive enough.
Keep in mind that for 35 out of the 40 years of each participants career, they should be long-term investors unconcerned about short-term market events. A risk appropriate asset allocation that is not changed in response to market events can reduce the effects of ambiguity.
Robert C. Lawton is president of Lawton Retirement Plan Consultants, LLC a Registered Investment Advisory firm helping retirement plan sponsors with their investment, fiduciary, employee education and compliance responsibilities. He may be contacted at firstname.lastname@example.org or 414.828.4015.
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