One of the most basic investing mistakes is focusing on a past investment outcome without regard to the process or factors behind it.
This month's article is the 22nd 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 investments in the retirement planning process: outcome bias.
Outcome bias, an information processing bias, refers to the tendency of individuals to decide to take a course of action based on the outcome of past events rather than by observing the process through which the outcome came about.
Here's a simple example of outcome bias: Ann's friends are back from an amazing tropical beach vacation in Phuket, Thailand. The weather was glorious, full of sunny days, mild temperatures, and calm, crystal-clear water.
Ann is enchanted by their stories, so several months later she decides to go see it for herself. She has a miserable time because she's there in monsoon season when the seas are choppy, and it rains almost constantly. She made her decision based on the lovely outcome her friends had months earlier rather than doing her own homework and finding the best time of the year to holiday in Thailand.
Investment Implications for Retirement Planning
A classic example of the outcome bias in the retirement realm can be observed when clients make poor decisions about their investments because they look only at one piece of the puzzle--for example, a mutual fund's track record--and don't also take the time to understand the risks the fund manager took to achieve the returns.
An investor might think, "This manager had a fantastic five years; I am going to invest with her," rather than understanding how such great returns were generated or why the returns generated by other managers might not have had good results over the past five years.
Often, investment managers who have produced good returns in recent periods can experience mean reversion. During these periods, these managers underperform. An investor needs to understand why the manager is performing well to know if performance will continue (was it luck or skill?).
Counteracting Outcome Bias
I have seen outcome bias in action on many occasions with my clients. The U.S. real estate bubble of the 2000s provides some examples. During the early part of the decade, I encouraged some of my clients to enter the real estate market. During the latter part of the decade, particularly in 2006-07, I steered many of my clients away from the real estate market due to excessive valuation of that asset class at that time.
It is human nature to want to follow the crowd, especially when many people are making money from real estate. But those who did not examine the factors that accounted for the strong results, such as very low starting prices and super-low interest rates, did so at their peril.
One of the most basic mistakes in investing is focusing on the investment outcome without regard to the process used to create the outcome. Investors need to pay attention to valuations and historical prices, not just the most recent returns/performance. This analysis can often determine the future outcome of investments.
Advisors have a great opportunity to gain trust and credibility by steering their clients away from overvalued assets. In short, my advice is to always ensure you and your client are:
1. Examining the factors that account for the results
2. Considering the process used to create the outcome
3. Taking a longer-term perspective rather than just focusing on recent outcomes