You might not be able to teach an old dog new tricks, but you might be able to train your brain into doing right by your money.
Editors of a soon to be published book about investor behavior reveals that many mental mistakes and emotional issues influence the decisions made by retiring investors. Retirees must be aware of the importance of this influence.
"Although retirees cannot avoid all behavioral mistakes, people can reduce their effects," wrote H. Kent Baker, professor at the Kogod School of Business at American University in Washington, D.C. and Victor Ricciardi, an assistant professor at Goucher College in Baltimore.
Baker and Ricciardi, wrote in an email, "This requires understanding one's psychological mistakes and emotions and resisting the tendency to engage in such behaviors." "Retirees, with the advice of a financial planner, should develop and follow a disciplined investment strategy, assess their level of risk tolerance, establish and appropriate asset allocation strategy and rebalance portfolios at least once a year." Baker and Ricciardi are the editors of "Investor Behavior: The Psychology of Financial Planning and Investing".
So, from Baker and Ricciardi's vantage point, what are the most important things that retirees and those saving for retirement need to know about investor behavior?
Overconfidence vs. Status Quo
Often some investors exhibit overconfident behavior resulting in overtrading of their investment portfolios, wrote Baker and Ricciardi, the latter of whom is also the coordinator of Behavioral and Experimental Research for the Social Science Research Network.
Other retirees suffer from inertia and under-manage their investments.
"A compromise would be to create a solid approach between these two biases," they wrote.
Trust and Control
"Retirees need to create a balance between trust and control in the relationship between themselves and their financial planner," wrote Baker and Ricciardi. "Retirees who place too much trust in financial experts or relinquish control about financial decisions can suffer," they wrote. "The Bernie Madoff scandal is an example." Yet, retirees who lack trust or are overly controlling are unlikely to accept the advice of a financial planner." they wrote.
Retirees who take too much risk by not diversifying their portfolios often experience high levels of worry. "If they can't sleep because of their anxiety about their risky investments, they should consider rebalancing their portfolios to contain more conservative asset classes." Baker and Ricciardi wrote.
Lack of Self-Control
People often lack self-control and prefer spending money today rather than saving for the future, such as investing in an annuity. "To potentially overcome this situation, they can reframe the issue." Baker and Ricciardi wrote. "That is, retirement savers can frame the annuity decision as a source of funds they can spend for playing golf or taking a vacation when they retire."
Age and Financial Literacy
As individuals enter their 60s, their financial literacy and cognitive decision-making often starts to slowly decline. "Retirees can use aspects of financial planning that cope with the aging process in later years to ensure they can maintain their investments and avoid financial scams" Baker and Ricciardi wrote. "Evidence suggests that older adults make more financial mistakes than middle-aged adults."
So given that all that, what should retirees do (or not do) with their investments, given the findings in Baker and Ricciardi's book? Here's what they had to say:
1. Don't ignore the detrimental effects of inflation on fixed income and financial assets. For example, as inflation increases, the required rate of return on bonds increases, resulting in a decrease in bond prices.
2. Don't react emotionally to news stories or short-term trends about the stock market.
3. Don't chase past performance. Mutual funds attract investors by increasing their advertising on high performing funds. Using past performance as a strategy rarely works. Thus, retirees should avoid jumping on the bandwagon and following the herd.
4. Don't ignore the effect that personality, mood, affect, and cognitive biases shape investment and trading decisions.
5. Don't fail to have a diversified portfolio. Putting all your eggs in one basket is not a good idea from an investment perspective.