Stock Market Volatility Puts Spotlight Back on ‘Behavioral Economics’

  Albuquerque, NM - 06/27/2016 (PRESS RELEASE JET)

The evidence is in—investors are their own worst enemies.

A widely-cited statistic from investment research firm, Dalbar, finds that the stock market returned 12 percent annually in the roughly two decades between 1984 and 2002, one of the longest bull markets in United States history. In contrast, the average mutual fund investor earned a paltry 2.6 percent for the same period.

The reason for such stark underperformance has a lot to do with investors’ inherent—and often unconscious—biases, say financial professionals. Indeed, recent stock market volatility, including the worst January performance start in history, has refocused attention on the budding field of behavioral economics.

Far from new-age, behavioral economics has proven itself a force in understanding how the conscious versus unconscious portions of the brain can affect financial decisions, and what may and may not lead to better investment decisions.

“One of the assumptions economists make is that individuals are fully rational,” Dr. Daniel Kahneman, a professor at Princeton, explained soon after he won the 2002 Nobel Prize in economics for his work in the discipline. “If you want an easy introduction to behavioral economics, it’s economics without making the assumption that [investors] are fully rational or that they have perfect self-control.”

The awareness of such irrationality in decision-making got a major boost from Major League Baseball as the subject of bestselling book Money Ball and the 2011 movie of the same name starring Brad Pitt. And while sports often provide the easiest examples of the possible effects of irrational decision-making, retirement planning is where it’s too often felt. Market timing, performance chasing, herd mentality and a host of other self-defeating behaviors can do lasting damage to even the best-laid and properly-prepared retirement plans.

“These behaviors, and the investment strategies that result, mean more volatility,” says Phil Gordley, an Investment Adviser Representative of AE Wealth Management, LLC, insurance professional and president of Core Financial in Albuquerque, New Mexico, who makes a habit of stress-testing pre-retiree investor portfolios in various market environments. “The investor might experience a gain in one year and a loss the next year, but potentially end up with an average return of 5 or 6 percent annually for an extended period. Yet there are strategies utilizing conservative investments and insurance products, like annuities, that may be able to give you similar returns without the volatility. In our experience, this type of approach gives our clients more confidence in their financial strategy, knowing that a portion of their retirement assets are protected from market risk.”

It is important to remember, however, that all investing involves risk, including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Protection benefits generally refer only to fixed insurance products, not securities or investment advisory products. That’s why, if you choose to be invested in the market, it can be a good idea to have a portion of your assets in products with protection benefits, but be aware that insurance and annuity product guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company.

At issue is the fact that, as with politics, too many investors identify as moderates when describing their risk tolerances, when in reality they are anything but, signaling a subconscious bias toward more aggressive strategies at a time when the opposite—a reduction of risk—is likely warranted.

The argument for overall risk reduction has to do with percentages, experts say; simple math dictates that a 50 percent loss—something not unheard of during the economic crisis of 2008—requires a 100 percent gain just to break even. And when you couple investment losses with the fact that retirees may be withdrawing funds from their investment accounts for day-to-day living expenses (further decreasing the amount of retirement assets, which are needed to help recover from any losses) and the challenge becomes clear.

“The importance of getting a positive return, or protecting retirement assets from market loss, increases exponentially as one nears retirement,” Gordley adds. “Losses generally hurt more than gains will help in retirement, because there is less time to recover from market downturns before income is needed. The consistency that accompanies a low-volatility financial strategy and one that often includes fixed income products, like annuities, can aid in the planning process.”

For more information, please visit http://www.corefinancialnm.com