Our all-too-natural tendency to seek out information that supports our pre-existing beliefs can be dangerous to our financial plans.
This month's article is the 14th in a series called "Behavioral Finance and Retirement," which is intended to provide insight to advisors on the unique needs and financial behaviors of clients who are entering that period of transition called "retirement."
I put retirement in quotation marks because people today are not retiring the way they used to. The days of the retirement party, the gold watch, and sitting out one's years doing crossword puzzles and watching "Wheel of Fortune" are over for most people.
We've all heard the analogy that the baby boomers are like a baseball going through a garden hose. Well, the baseball is getting to the end of the hose, and it's not leaving without a bang! And before it leaves, it will be a financial force to be reckoned with.
To serve retired clients properly, there are some key themes that advisors need to be aware of:
1. People are living longer than ever thanks in part to medical technology and better living habits such as diet and exercise. This is extending the length of time people are in a nonworking phase of life.
2. People's definition of retirement is changing, which is having a major impact on how individuals manage their finances.
3. In some cases, a certain segment of the population will have no choice but to produce some type of income after they leave the traditional workforce.
4. The responsibility of planning and investing for retirement has shifted in large part to the employee/retiree and away from corporations. As a result, behavioral biases significantly affect individuals who are entering or already in this phase of life.
In this article we are exploring another bias that affects investors in the retirement planning process: confirmation bias. Confirmation bias is a belief perseverance bias and refers to a type of selective perception that emphasizes ideas that confirm our beliefs, while deemphasizing or devaluing information that contradicts our beliefs.
In short, as humans, we believe what we want to believe, and we seek out information that supports our beliefs versus seeking information to the contrary.
Have you ever made a large purchase such as a TV or other major appliance after a lot of pricing research? After you made the purchase, did you go back to a website that is known to have higher-than-average prices to confirm that you made a good purchase decision? Did you look for sale prices after you made your purchase? Probably not, because it might list a lower price than you paid, and you don't want to think you made a bad purchase decision.
Put more simply, confirmation bias refers to our all-too-natural ability to convince ourselves of whatever it is that we want to believe. Because it makes us feel good, we attach undue emphasis to events that corroborate the outcomes we desire, and we downplay evidence to the contrary that arises.
Investment Implications for Retirement Planning
Let's consider a specific investment example of confirmation bias in retirement. Suppose a 65-year-old retiree needs to decide how much risk to take on in her portfolio. You, as her advisor, suggest 65% in risk assets and 35% in risk-reduction assets, because she has a reasonably long time horizon (20-plus years), and she could use the extra return to support her lifestyle.
But as you are sitting down to have the discussion, she pulls out some articles she's read on risks to the global economy as well as geopolitical risks. She says she doesn't want to take on so much risk--she prefers 40% risk and 60% risk reduction. You run the numbers in your head and conclude that this allocation will not cut it in terms of meeting her return needs over time. Yet, she references the articles as confirmatory evidence that she should have a lower risk allocation.
This is classic confirmation bias. She is seeking out information that confirms her initial belief that she needs a lower risk allocation. The reality is, if she is investing for 20 years, current events should not necessarily impact her long-term investment policy.
Countering Confirmation Bias
My advice for overcoming confirmation bias, as with many biases, is to learn to recognize it in action. I can't tell you how many times my team members at work and I say to each other, "Isn't that confirmation bias in action?" Given my background and interests, we tend to speak about behavioral finance frequently--especially behavioral biases. You might consider doing so, too!
My second piece of advice for overcoming confirmation bias is to intentionally put more weight on contradictory information than you typically tend to do. Play devil's advocate with yourself or your client and make a case for how contradictory information could be right. You might be surprised when you actually change your mind based on the contradictory information! If, however, after this process, you can objectively believe that your original view is still valid, then you should proceed with your course of action.
Realizing these signs in your own behavior can help you, as an advisor, recognize and address confirmation bias with your clients.