It’s human nature to opt for a sure thing when the stakes are high. In retirement, we need to know our savings will last, and the double whammy of insecurity around income and uncertainty about how long we’ll be alive leads us to make investment decisions based on a fear of losses. This article explains how this fear becomes an information processing bias that can affect your investment decisions and reduce your investment income. At the end, we offer advice to manage this instinct properly to increase your retirement income.
If we knew exactly what was around the corner, we’d arrive fully prepared. Instead, the future is uncertain—and this is felt particularly keenly during retirement.
The questions seem endless. How long will I live? How healthy will I be? What unexpected expenses will I have? When should I start drawing on my government pensions? What will the markets do? Should I go back to work? When should I convert my RRSP to an RRIF? If you have a spouse or partner, you can repeat the questions, subbing in their name for the first-person pronouns.
If these questions are keeping you up at night, they’re probably affecting your investment decisions. That’s because periods of uncertainty magnify our underlying emotions, and emotional decision-making is more likely to be biased.
HOW OUR BIASES AFFECT INVESTMENT DECISIONS
We’ve explored the mental shortcuts that lead to biased information processing and how these biases affect investor behaviour in two other posts: 5 ways fast thinking is hurting your investments and 5 more biases that are hurting your investments. They’re excellent sources of information on biases and investing, based on Alan Fustey’s book, Risk Financial Markets & You. (We’re giving away free copies of Alan’s book if you’re interested.)
For our readers in a hurry, here’s a quick summary of those articles.
Humans have evolved to respond quickly to life-and-death situations. Back in the primordial swamp, fast thinkers were more likely to outrun a predator and pass their genes to the next generation. Thinking quickly doesn't allow us to systematically gather evidence and subject it to a disciplined evaluation process. Instead, we have to rely on mental shortcuts. The emotion of the moment (“Yikes! A tiger!”) triggers the need to act quickly, which triggers our fast thinking brain and our biased information processing.
The top 10 biases that can impact investment decisions are:
Herd bias—our tendency to follow the crowd
Uncertainty aversion—our bias towards known risks
Anchoring bias—making decisions using an arbitrary reference point
Confirmation bias—seeking evidence that confirms our beliefs
Availability bias—relying on information that’s top of mind
Representativeness bias—making connections between things that aren’t necessarily related
Affect bias—mixing up feelings with facts
Overconfidence bias—thinking we’re better than we actually are
Hindsight bias—assuming we can predict the future because we know what happened in the past
Loss aversion—focusing on avoiding loss over securing gain.
It’s this last bias—the fear of loss—that can have an unfortunate impact on your retirement income from investments.
WHAT IS LOSS AVERSION?
Loss aversion is the strong dislike that most of us have to loss. In fact, we dislike losing so much that we prefer avoiding a loss to acquiring a gain.
Loss aversion was first demonstrated in studies by Tversky and Kahneman. The studies suggested that our brains evaluate the emotional impact of losses and gains differently, with losses producing an impact that is more powerful than gains.
Other research by Kahneman has shown that our fear of losses is more powerful than our pleasure from gains by a factor of at least 2:1. Another study found the average person is willing to risk a potential loss only if they stand to gain at least double that amount.
The bottom line? We hate to lose more than we love to win.
Here's a simple example. Imagine that you have the good fortune of finding $50 on the sidewalk. You put the bill in your pocket and walk to a nearby store. Once inside the store, you reach into your pocket to pay for a purchase and discover that the bill is gone. Somehow it fell out of your pocket. How would you feel?
Chances are that you would berate yourself over losing the found $50, because the loss results in a powerful feeling even though the true economic impact to you is $0.
LOSS AVERSION IS WHY WE OPT FOR THE SURE THING, EVEN WHEN IT'S THE WRONG THING
A fear of losses is the reason why retired investors often go for low interest-bearing GICs, treasury bills and bonds—traditional fixed income retirement strategies. These investments are perceived as “low-risk” because there is some sort of guarantee. You won’t lose anything, you tell yourself. Or not much, anyway. And not losing is better than gaining, when we’re under the influence of loss aversion.
The truth is, these investments are high risk retirement strategies given today's financial situation. In the case of GICs and treasury bills, at today’s interest rates their rate of return won’t even cover inflation. By the time you need the money, it’ll be worth less than when you invested it. Inflation will erode the value of bonds, as well. But bonds have an additional layer of risk when interest rates are rising, since their rate of return goes down when interest rates go up.
In most cases, even retired investors should have some of their investments in higher risk options—investments where there is greater likelihood of increased gains over the long term, but greater risk of short-term losses. The key is to understand that even a small gain is a loss if it doesn’t give you the income you need for retirement.
LOSS AVERSION IS WHY WE WON'T SELL LOW, EVEN WHEN IT'S HIGH TIME
Loss aversion explains our reluctance to sell investments that will result in a loss.
Imagine that within your investment account you purchase two securities. If you're like most investors, these initial purchase costs will now become your reference points for the success of your investment decisions. (That’s the anchoring bias at work.) One security appreciates and one security declines. You now need to make a withdrawal from the account, so you will have to sell one security to raise the funds. You don’t have any new information about either security that may influence your opinion of the future prices of the two securities. Which one would you sell?
Most people would choose to sell the security with the gain, even though the transaction will produce a capital gain that will require a future tax payment. The most rational decision would be to sell the security with the loss, since no tax would be owed and the capital loss can be carried forward indefinitely for tax purposes.
A study by Odean (1998) confirmed the tendency of individual investors to hold losing investments too long and sell winning investments too soon. The study analyzed trading account records for 10,000 investors at a discount brokerage firm. Throughout the study, investors’ reference points were assumed to be their purchase prices. These investors demonstrated a strong preference for selling winners rather than losers.
FORGET YOUR FEAR OF LOSS? EASIER SAID THAN DONE
Because loss aversion is about emotion, not logic, it's hard to overcome. A good place to start is with awareness. Look for instances when your retirement investment decisions may be motivated more by potential loss than potential gain.
Some loss aversion behaviours investors need to be aware of:
You’re holding onto investments that keep losing value and are fixated on what you paid for them.
You're sentimental about investments you’ve had for a long time, especially if they were given to you, regardless of whether they fit your financial plan.
You avoid thinking about the less pleasant aspects of retirement, such as long-term care and estate planning.
You’ve suffered from a market crash or other past negative investment experience and find yourself thinking "Once burned, twice shy."
You justify risky investment behaviour under the guise of “I need to make up that loss!”
Once you're aware that you may be acting out of a fear of loss, you can take steps to resist temptation. Focus on how your portfolio is performing as a whole rather than how the value of individual investments may be rising or falling. Think about the overall level of wealth you can attain instead of focusing on how much you've gained or lost in relation to a subjective reference point, such as an initial purchase price. Finally, do the math when it comes to selling an underperforming investment versus a high performing one. Can you make up the loss when you write it off? What price will you pay if you sell a good performer too soon?
When it comes to loss aversion—or any investment bias, for that matter—professional guidance can be very helpful. A financial advisor or portfolio manager can help you make well researched, logical decisions that are in keeping with your retirement plan and don't potentially expose you to greater risk in the name of averting loss.
Taking a more conservative approach to your investments in retirement will help you sleep better at night, and keep the fear of loss at bay. That doesn't mean opting for traditional fixed income investments, of course. Instead, invest in dividend-paying securities and alternative fixed income options that provide regular income and are less vulnerable to short-term swings in value, such as Bellwether's North American Disciplined Dividend Growth strategy.
In the end, anything that supports rational, reasoned investment decisions and keeps you off the emotional roller coaster of investment highs and lows will help you make better choices and ultimately increase your retirement income.