Since employees and their behavior are at the root of most decisions about retirement plan participation and how individual accounts are managed, insight into behavior that affects those decisions can be a useful tool in understanding how those choices are made.
In a July 9 webcast, “Behavioral Finance: Managing Emotions for Better Outcomes,” Amanda Manthey, an internal advisor consultant at PIMCO, offered a discussion of behavioral finance, a way of examining what’s behind investment decisions that goes beyond conventional ways of understanding decisions and what fuels them. Manthey argued that conventional finance ignores how real people make decisions.
There is a “constant struggle between the left and right sides of the brain,” said Manthey, adding that it “occurs with most decision-making.” Intuition, she said, “has a very significant influence on how investors make decisions.” And yet, she indicated, intuition can sometimes lead one to incorrect decisions – and so needs to be balanced by deeper thought and analysis.
Investment results, said Manthey, “are more dependent on investor behavior than on fund performance.” But she warned that there can be a pitfall. “Investors are generally their own worst enemy,” she said, and that behavior can have a cost. For instance, she noted that there can be a gap between the performance of investments made by the average equity fund investor and the long-term returns for the S&P 500 Index over 20 years. The difference, she said, can be as small as 2 percentage points. That “behavior gap,” as she called it, could be the impetus for poor investor choices. “Two percent doesn’t seem like a lot, but over time it is,” she said. Manthey suggested that a professional can help individuals to be patient and explain the importance of a more long-term perspective regarding investments.
Manthey cited various behavioral factors that can affect how people manage their retirement funds and the way they are invested:
The illusion of control. “We can control taxes and expenses,” said Manthey, but not future outcomes. “Trading-oriented investors believe they possess more control over outcomes because they are ‘pulling the trigger’ on decisions,” she said.
Hindsight bias. Hindsight bias – a tendency to lend importance to what has happened – makes investors perceive investment outcomes as predictable even if they are not, Matheny said. It can give them a false sense of security, she warned, and could lead to excessive risk-taking.
Confirmation bias. This tendency, Matheny said, leads investors to observe, overvalue or actively seek information that confirms their claims and to ignore or devalue that which discounts their claims. For instance, she observed, it can lead investors to seek positive information concerning their portfolio holdings, but to ignore negative opinions.
Mental accounting. How investors look at various sums varies based on where they mentally categorize them, Matheny said. For instance, she said, risk-averse investors prefer to put assets in “safe” buckets. The problem with that, she said, is that “if all money is viewed as ‘safe,’ it could lead to suboptimal returns.” It is better to look at a portfolio as a whole unit, she suggested, rather than as being composed of individual buckets.
Anchoring. Anchoring, which she said occurs when investors are influenced by purchase prices or arbitrary price levels, is “one of the most powerful concepts in behavioral finance.” It prevents investors from viewing investments holistically, she said.
Framing. Investors sometimes respond to various situations differently based on the context in which a choice is presented, Manthey said. And a “gain or loss” perspective matters, she said. For instance: if a medical procedure has a 90% success rate, one either can focus on the 90% who are alive after the procedure, or the 10% who are not.
Recency bias. Investors often look at recent returns when making important financial decisions, Manthey said. “It’s easier to emotionally validate a choice when we follow a trend,” she said.
Loss aversion. Manthey noted that basketball great Larry Bird once said that “losing hurts worse than winning feels good” in explaining that the pain of loss can prevent investors from unloading unprofitable investments and can cause them to take risks to avoid the pain of losing an investment.
Status quo. Investors can be predisposed to choose options that keep conditions the same, Manthey said.
Overconfidence. The tendency to overestimate or exaggerate one’s ability to successfully perform a given task can influence investors, Manthey warned.
Addressing Bad Behaviors
Portfolio rebalancing, Manthey suggested, offers a solution to the problems these tendencies pose. She said that it can:
- Address unintentional portfolio allocation “drift”
- Instill a disciplined approach to investment decisions, minimizing behavioral tendencies
- Ensure adherence to stated investment policy guidelines
- Reduce overall portfolio volatility with the potential for higher returns
- Require the investor to do what is emotionally uncomfortable, but financially productive: buy low, sell high
Manthey also suggested that investment policy statements may help, because they:
- Provide a disciplined approach during periods of volatility
- Reduce behavioral tendencies
- Manage risk
- Confirm benchmarks for performance monitoring
- Maintain asset allocation
- Implement selected guidelines and methodology