Getting past emotional investing

Conventional finance theory says that humans are inherently rational beings who look to investing as a way to maximize their wealth and to ensure they can maintain a comfortable standard of living as they age. When it comes to money, so the theory goes, humans behave without emotion or bias.

But if these assumptions hold true, how do we explain the decision to buy lottery tickets regularly when we know our odds of winning the jackpot are near zero? And what of those individuals who, faced with sudden economic turbulence, choose to abandon their savings plans even though logic dictates this action will decrease their financial means later in life? Enter behavioural finance theory, which examines the roles that understanding, emotion and social interaction play in how individuals make financial decisions.

Olivia S. Mitchell, an economics professor at the Wharton School of Business in Philadelphia, says that human beings aren’t hard-wired to save. “Saving is not intrinsically attractive. We are animals, and mostly what we like to do is consume—spend more and satisfy various needs we might have. Saving is, by nature, a deferral of consumption.”

Throw in a turbulent economic situation like the one we’ve been in since 2008—where any money saved in safe investments grows at a snail’s pace and anything put into public markets risks being wiped out—and Mitchell says people’s natural aversion to loss kicks in. She says her 20-something daughters both know they need to start preparing financially for retirement. But she says they’re hesitant to make a concerted effort to grow their savings for fear of losing their hard-earned money in volatile markets.

“I kind of understand that position,” says Mitchell, who is also executive director of Wharton’s Pension Research Council. “But that’s not necessarily where we should leave the conversation.”

Finding a balance
Of plan members polled in Benefits Canada’s 2011 CAP Member Survey, 83% say the financial downturn has made them more aware of the need to save for retirement. Despite this, the survey indicates that they’re actually saving less, with member contribution levels to capital accumulation plans at a mean of 4.9% in 2011, down from 7.3% in 2007.

And, members are making excuses to justify their lack of saving for retirement. According to the survey, living expenses were cited as a key reason for not saving by 55% of plan members, and 40% of survey respondents were not yet enrolled in their employer-sponsored plan. About one-third of members (33%) and 43% of non-members said their inability to save for retirement was due to “just getting by” financially.

Serge Pépin, vice-president, investment strategy, with BMO Global Asset Management, says that the 2008 downturn made people more aware that they need to approach saving for retirement as a long-term commitment. But continued
market shocks over the past few years—including problems in Europe, China and, most recently, the U.S. with the fiscal cliff showdown—have kept many Canadians from making meaningful investments.

“For most Canadians, I’m not too sure how honest we are with ourselves in terms of how we react to certain events,” he says, pointing to BMO’s recent Psychology of Investing survey series, which found that 79% of Canadians admit fear is keeping them from investing. “Although we may have a long-term view, any type of negative event in the market may cause you to remove yourself from it completely.”

Pépin says this tendency toward inertia illustrates a lack of financial understanding. He says plan sponsors and the financial industry need to work harder to make people understand that markets will fluctuate over time and that taking a long-term approach to investing will mitigate these ebbs and flows in most portfolios.

Better financial literacy will also help people understand that while paying off debt is good, it shouldn’t necessarily be done at the expense of saving for retirement—something the BMO survey indicates is a problem, with 83% of respondents pointing to debt repayment as a key reason preventing them from investing in their future. “Set aside a certain portion of money and treat yourself as a debt,” advocates Pépin, who suggests that people need to learn they “owe” themselves 10% of their income for saving and investing.

Time to talk
According to Mitchell, those who grew up during the 1929 stock market crash and subsequent Great Depression have a heightened cynicism toward doing anything risky with their money, such as investing it. But, of course, such risk is needed in order to grow retirement savings to appropriate levels. And, she says, those who are just starting out with saving and investing in the current environment risk similar fears. “So the question is, What will that portend for the future?”

Mitchell agrees that more focus on financial education can mitigate this risk. She says research indicates that young people who attended schools in American states that mandate a financial literacy curriculum are more inclined to have a financial plan that includes building a retirement nest egg.

Karrina Dusablon, director, education and communication services, with Desjardins Financial Security, says that if there’s a positive to economic turbulence, it’s that it helps plan sponsors and providers identify those who really need help with their retirement planning. “There are those people who put their head in the sand,” she says. “But I think they’ve had their head in the sand for a long time; they just leave it in for a bit longer during turbulent times.”

The other members, she says, are ready to learn about their plan and how to use it to save for their retirement. In the 2008 CAP Member Survey, 52% of those polled said they understood their plan; in 2011, that figure dropped to 31%. Dusablon says this suggests that plan members freaked out by the downturn are realizing they need help.

“As humans, we have an innate tendency to inertia,” she says. “We hope everything is going to go well and that we’re always going to get 10% returns. [The financial crisis] has made more people conscious that things aren’t like they used to be and that they have to take action.”

Increasingly, plan members are looking to their employers for this help: in the 2009 CAP Member Survey, only 5% said they turned to their plan sponsor for plan advice, compared with 21% in 2011.

This suggests that effective plan communication is key to helping members figure out how to take action, says Dusablon. But to get members to pay attention, how plans communicate is just as important as what they communicate.

“We need to find a way to explain what’s in it for them,” through messages personalized according to members’ demographic and family situations and their retirement time horizon, and through calls to action.

“As an industry, we’re trying to do everything we can to educate people. I think there’s a responsibility of plan members to take action. What we need to focus on is the call to action—not only educating but showing them exactly how [saving for retirement] relates to them.”

Dusablon likens helping members to better understand their plan and market movements to building a house. “Someone will go through turbulent times well if they feel they have a foundation beneath them.”

Neil Faba is associate editor of Benefits Canada.

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