Risky Behavior: Behavioral Finance Can Reduce Risk

Like moths to a flame, investors often behave in ways that will lead directly to the outcomes they most fear. Behavioral risk is not as well recognized and can be difficult to plan for, but it governs how people make financial decisions and can uncover the biases that may handicap decision-making, according to ”Mitigating Behavioral Risk,” Salka’s paper on how behavior can adversely affect retirement planning. 

Using behavioral finance—a field of research that combines psychology and economics to examine why people make decisions that are not always economically rational—Salka said in ”Mitigating Behavioral Risk” that people’s own fears can have a negative impact on their retirement planning. Behavioral research attempts to understand how people can save adequately and invest appropriately for retirement, despite fears that might lead them to behave in financially self-destructive ways.

“As a discipline, behavioral finance has been evolving over the years, and it’s making a difference,” Salka told PLANADVISER. The discipline has already been used successfully in plan design to meet challenges to retirement planning such as the use of auto features to overcome participant inertia. “That’s where you’ve had the most success,” she said. “You’ve got automation to work for, as opposed to against, participants.” Auto features also address time discounting, or the reduced weight people give to something far in the future. “People tend to think that if something’s more than a few years off, it recedes in importance,” Salka noted, and automatic increases in deferral rate take the onus off the participants, who are likely to delay making the decision.

Most people are averse to loss, Salka said. In 1979 two financial behaviorists were the first to point out that people perceive more hurt from a loss than they do pleasure from a gain. Sensitivity to loss often leads people to opt for a smaller, but certain gain over a higher potential one. Recent research has found that loss aversion is even stronger among retirees, Salka said. They seem to weigh losses about 10 times more heavily than gains.

“People tend to get more conservative as they get older,” Salka explained. “If you have fewer assets you’re more conservative, because you have less of a margin of error. You can’t afford to take risks with a smaller nest egg.” Savings, gender, age are the factors that influence how risk-averse investors are, Salka said. “Decisions made during the accumulation phase are critical, but the decisions made at and after retirement are especially crucial because if people make poor economic decisions, they have less time and ability to make up any financial losses,” she explained. The stakes get higher as people get closer to retirement, so the time horizon becomes compressed. 

Asset allocation within target-date funds can address risk-averse investors, Salka said, since they are set up for the year of retirement, and the participant doesn’t have to make decisions around investments. “Particularly among the young, who are  averse to risk, at a time when they are more able to take on investment risk,” Salka said, this is a feature of plan design that helps people to invest more appropriately. As well, TDFs addresse other risks, such as people’s naïve diversification strategies. “People select their investments based on the number of lines on the enrollment form,” Salka said. “They use the wrong cues, and both managed accounts or TDFs can mitigate these behaviors.”

“Choice is another aspect of plan design to consider. ”People get overwhelmed by too much choice,” Salka said. Pointing to the body of research that examines peoples’ responses to being confronted by too much choice, she described making a simple purchase, such as a pair of jeans. “You used to just have to know your size,” she said. “But now there are straight leg, bootcut, low-rise, black, white and other colors to choose from. A simple choice can be paralyzing. Within a retirement plan, defaults tend to be very helpful, because there are fewer investment choices.”

Planning plays a big part in retirement preparedness and confidence. “Our research suggests you have an easier time if you have a written financial plan, if you’ve saved enough and if you’re working with an adviser,” Salka said. Much comes down to confidence. There are always factors people can control, and some they cannot.

To help increase peoples’ confidence, plan sponsors can help participants by giving them access to planning, to advice and education. The more a plan sponsor can provide tools, services and access to advice to mitigate and manage those fears, you’re more likely to have participants who are ready for retirement. “Sponsors have the same interest in having their participants be able to retire as you think about workforce planning,” Salka said. “It’s not just good for the participants. It’s good for the sponsor.”

“Mitigating Behavioral Risk in Retirement” can be read online at LIMRA’s website.