Advisors not only help clients make good decisions, but they help them avoid making bad ones, too.
This is the 24th article in "Behavioral Finance and Retirement." This series is intended to provide insight to advisors to 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 are not retiring the way they used to; the days of the retirement party, the gold watch, and sitting out one's years on the couch doing crossword puzzles and watching "Wheel of Fortune" are over for most people.
And 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 retiree 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 habits such as diet and exercise. This is extending the 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 away from corporations … and behavioral biases significantly affect people entering/in this phase of life.
Another bias affects investments in the retirement planning process: regret aversion bias.
Understanding the effects of regret aversion bias is very important to advisors. People exhibiting regret aversion avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Basically, this bias seeks to avoid the emotional pain of regret associated with poor decision-making.
A simple example of regret aversion occurs every day in restaurants. Suppose you are with a companion having a quiet dinner out. The waiter arrives to take your order, and you are torn between choices. You can have the steak that you've tried many times and know you will enjoy, or you can try something new, like the fish special that sounds appetizing. You decide to go with the steak, but, even after enjoying it, you may still wish you had taken the small risk and tried the fish. This is a classic case of regret aversion.
Investment Implications for Retirement Planning
Let’s look at two examples of regret aversion in the financial world: one in the realm of investment gains and one in the realm of investment losses.
In the realm of investment gains, retiree investors may fear, in hindsight, that they will make the wrong decision when an investment is performing well and not sell or rebalance.
For example, if an investment is doing well, there is an urge to "take the money" and run as opposed to sticking with a plan. If the investment goes down, they will avoid the regret of not selling.
In the realm of losses, retiree investors may avoid investing when markets are down because they fear they may regret entering too early if the market continues to drop.
The year 2008 was a great example. As we know, the best time to invest is when markets are crashing. Many did not, however, for fear they would lose even more. And the problem with not taking action when markets are down is that many people find it hard to invest when markets rebound. Even today, there are investors who have high levels of cash because they’ve been waiting many years for the market to drop. It hasn't.
Helping Clients Overcome Regret Aversion
I often see regret aversion in action in my practice. It can be very hard for clients to stick to a disciplined plan. This is especially true during severe market corrections, such as the global financial crisis of 2008.
Your role as a financial advisor is to keep your clients on track toward their long-term financial goals. Encouraging them to periodically rebalance their portfolios in a disciplined way is probably the best antidote for regret bias.
One of my clients used to remind me of my role in this aspect, by using the bowling analogy that my job was to keep him from "throwing gutter balls." In other words, he didn't want to regret making decisions that had negative consequences.
Sometimes the role of the advisor is to not only help clients make good decisions, but also to help them avoid making bad ones.
Michael M. Pompian, CFA, CAIA, CFP is an investment consultant to ultra-affluent clients and family offices and is based in St. Louis. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients.