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Behavioral Best Practices for Pre-Retirees

Jason Stipp

Jason Stipp: I'm Jason Stipp from Morningstar.

It's Retirement Readiness Week on This week we'll be helping pre-retired investors get hands-on with their portfolios. Of course, a big piece of that is not just which investments you buy, but when you buy them and how you think about your portfolio, so-called behavioral finance.

Here to offer some tips about behavioral best practices for pre-retirees is Morningstar's Christine Benz, our director of personal finance. Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: We do know that investors can be their own worst enemies sometimes because of the way they think about investing or the behaviors that they engage in as they're investing. So, beyond just thinking about your actual investments, it's important to think about how you invest, and the practices you use.

On that front, you have a few tips for us today about how you can be on your best behavior, some ways to basically stack the deck in your favor. The first one has to do with those all-important retirement accounts and some easy tips that you can implement with those accounts to make sure you stay on track.

Benz: That's right, Jason. Retirement plan overseers have noticed that when participants are nudged in a certain direction, they tend to exhibit better behaviors. So, most 401(k) plans have a couple of options that you can switch on.

First of all, many 401(k) plans automatically opt participants in, and they have to opt out if they don't want to participate. So, that's something that participants often do, and it and often helps their results. You can further nudge yourself in the right direction by taking advantage of "auto escalation," which means that when you get a raise, your contribution to your 401(k) plan or your 403(b) plan or 457 automatically goes up. So, it's good to opt in to a features such as that to sort of take advantage of your natural tendency to maybe do nothing. It will help you exhibit better behavior.

Then there are also programs that automatically rebalance your account. So, left alone, your accounts will sort of drift to whatever has performed best, and that tends to increase the risk profile of your basket of investments. By selecting auto rebalance, periodically you're scaling back on those investments that have been performing really well, and you're tipping more money into those things that haven't done as well, which is actually a really good way to invest.

So, if you're investing within the context of a company retirement plan, those are some good features to check off when you first sign up. I would also say if you are contributing outside of the company retirement plan, also think about taking advantage of automatic investment programs, whereby you are contributing a fixed amount on a regular basis. It kind of takes that tendency to pull back on your investments when things aren't feeling so good about the market, and it overrides that tendency, and so you're putting money to work at a regular basis.

Stipp: It seems overall, a lot of these tips, getting auto-enrolled or enrolling in that 401(k) the first day you start your job, and getting that auto escalation implemented, really helps keep you disciplined as far as your investments.

So, if you're dollar cost averaging, you know that you're always going to be putting in a certain amount of money and that's going to help you especially when the market's doing poorly, when it's really hard otherwise to invest if you're not in that automated plan.

Benz: Exactly, exactly. It's just a good way to instill discipline in your investment program.

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Stipp: Another thing I know, folks, as they're approaching retirement, they're going to start checking in on their portfolios more frequently, they'll probably be talking with their friends and family about how their portfolios are doing as they're getting closer to those retirement years.

You wrote an article on recently that talked about how you should place your focus on your overall retirement portfolio. We often will get caught up in talking about [fund-by-fund] performance, and is it better than other people's funds? But that's not always the best way to look at it when you're trying to reach that retirement goal?

Benz: I think that's exactly right, Jason.

To the extent that you can anchor your decision making in actually how you are performing relative to your personal goal, that's really the healthy way to think about it, because otherwise you're liable to be distracted by [things such as], this investment is performing better than my investment that I've chosen, should I switch it up?

I think that by anchoring it in your progress toward your actual dollars-and-cents goal, that's a good way to override that tendency to focus on selecting the very best performing investment at any given point in time.

Stipp: The other important thing there is not just how your individual investments are doing, but also your savings rate. It's one of the key things you should be focusing on, because even if you have the best investments--better than everyone else's--if you're not focusing on what you are actually doing with the portfolio to save more, it's going to be hard to reach those goals.

Benz: There is no bigger contributor to whether you hit your financial goal or not than how much you personally have been able to save. So, a lot of financial planners have talked about 15% being a good starting point in terms of a savings rate. A lot of other planners say, given that most people do not have the helping hand of a pension these days, you probably would want to think about nudging that savings rate even higher, but that will by far be the most impactful decision that you make in your investment program.

Stipp: So, decent performance for most folks, provided they are saving conscientiously is usually good enough to reach their goals. Folks who try to maneuver around too much and get in to the best investments at any given time, probably would do themselves more harm than good.

So how does this translate, Christine, in how you do your portfolio check-ups--how often you'll check-up on your portfolio and the things you'll be looking for?

Benz: I think the key thing, when you are checking up on a portfolio, is to make sure that you have blueprint for that checkup. The best blueprint that I know of is an investment policy statement. It doesn't have to be anything fancy. But just saying, here is my dollars-and-cents goal that I hope to hit in year X, and here are the criteria that I'm going to use for selecting my investments and for monitoring them on an ongoing basis.

So, the idea is that you're giving yourself a template, when you do your checkup, that you're not going to get distracted by, oh this fund is in the 98th percentile--is that cause for concern? You're going to spend more time thinking about the fundamentals of the investments--have there been manager changes, has this company's profitability trend disintegrated. You'll focus more on those sorts of factors as opposed to performance.

And in terms of the frequency of these checkups, I always say that less is more. I think for most people a quarterly mini checkup is plenty. You could probably get by with just an annual checkup, and then focus at that time on how you're progressing toward your goal, also your asset allocation versus your targets, some of those big picture items rather than really focusing on the micro direction of various investments.

Stipp: Another behavioral factor we know, as humans we like to feel like we're in control. It seems like especially right now, a lot of the headlines seem very much out of our control. We've got the European situation that seems to be doing better and then worse and then better and worse. There is this notion of the fiscal cliff that's coming up in the shorter term. There are concerns about taxes going up at some point.

As an investor, and as you're doing these portfolio checkups, how should we think about these sorts of things that we see in the headlines every single day, but we probably can't really do anything about. We can do great harm to our portfolios if we're trying to react to them in real time. What's the best way around that?

Benz: You're right, that investors do have that tendency to want to try to exert control over things that they truly cannot control. That's why we see investors switch to cash, for example, at inopportune times. Or we see this strong pull toward bonds over the past several years, even as equities have gone up and up and up.

So, I think it's worthwhile to take a step back and think about that set of things that you, as an investor, actually have some power to predict and control. So, certainly keeping tabs on your investment costs in terms of your trading costs, whatever you're paying your investment advisor, whatever you're paying in investment management fees for the mutual funds that you might hold in your portfolio--that's something that's clearly within your control.

Your asset allocation is another thing that is generally within your control; you can try to create a plan that syncs up with the long-term direction that you hope to get in. So if you're getting close to retirement, you'd want to be taking equities off the table, shifting more into bonds. If you have a long time horizon, you'd want to think about having more equities. And also, as we discussed, the savings rate is another thing that investors control completely.

Stipp: So, the short-term noise are probably things that will work themselves out in the longer term, and you're investing for that longer term anyway. To the extent that you can tune those out, focus on what you actually can control, then hopefully, you'll feel better about your position of control overall in your portfolio and won't be trying to chase things around in the meantime?

Benz: Exactly.

Stipp: The other thing, Christine, is that sometimes, even though it's not natural to want to go out in the market when things are doing poorly or when the market's having some kind of a correction, this can actually be a good time to be in the market. And if you can change your behavior or thinking to understand that, actually, in a down market, if you continue to invest along some kind of disciplined plan, you can do better for yourself. What are some tips on helping to be contrarian?

Benz: Well, I think that the key thing is to sort of think like a budget shopper, and certainly if you liked something when it was full priced, you should like it even more when it's on sale. So, that applies to whole asset classes: We saw during the financial crisis, for example, equities became very beaten down, pessimism reigned over the whole asset class. In hindsight that was a fantastic time to think about investing. So, exercise contrarianism when it comes to whole asset classes.

Also to individual investments. So, if you liked a give fund manager, for example, a couple of years ago, he or she will inevitably hit that rough patch in performance. But if you took care in selecting that investment in the first place, chances are you should still like it--provided that the fundamentals of that investment are the same--you should still like it when it's a bit beaten down. In fact, you should like it even more and be prepared to add more to it at that time.

I think it's important to recognize that individual investors do have longer time horizons than some institutional investors might have for their investments. Really take advantage of the fact that you, as a small investor, can exercise some patience. You don't have to measure up to anyone else's performance standards. You can ride out those periods of temporary weakness.

Stipp: So, the important thing is, remember why you bought something. If those fundamentals haven't changed, if it's coming under a certain amount of pressure, it might be time to even consider putting a little bit more money toward it?

Benz: Exactly.

Stipp: Christine, obviously what you invest in is very important, but also how you invest, arguably, just as important. Thanks for offering these behavioral tips today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.