Behavioral Finance Investor Bias Can Crush 401k Participants
Behavioral finance investor bias can decimate the returns of 401k Participants. Behavioral finance investor bias can also make it difficult for plan fiduciaries to build a quality investment menu for 403b or 401k plans.
Behavioral finance is the study of why people make certain financial choices. When it comes to saving for their retirement behavioral finance investor bias enters the conversation. We have known for a long time, many workers chose the “inertia route,” letting their personal wants and confusion steer them away from saving in their workplace retirement plan. Then came automatic plan design features like auto enrollment and auto escalation, and we improved both plan participation and retirement readiness levels. The methods for deflecting inertia are not a panacea, but they did get the proverbial ball rolling in the right direction.
When it comes to investing, 401k behavioral finance investor bias is a tougher nut to crack, than inertia. Most people aren’t investing experts, so choosing which funds to include in a retirement plan account is a challenge, if not downright scary. The industry and the regulators have collectively mitigated the “fear factor” with plug and play investment options like target date funds (TDFs). Most plans today have adopted TDFs as a qualified default investment alternative (QDIA) — the option most participants are defaulted into when auto-enrolled. Interestingly, the behavioral finance investor bias is something plan fiduciaries and plan sponsors have some difficulty with, too. However, plan fiduciaries’ challenges lie in the actual choosing, managing, monitoring, evaluating and when necessary, replacing the funds in the retirement plan investment lineup.
Independent investment advisor, Fisher Investments, based in Camas, WA, published a thorough guide to help 401(k) plan sponsors and plan fiduciaries avoid some of the 401k behavioral finance investor bias and pitfalls of choosing a plan’s investments. They point out five behavioral finance investor biases that play a role in an employer’s decision-making process about plan funds. The guide is thorough and lengthy, and it is a complete read on the subject. You will find some of the main points of behavioral finance investor bias summarized here:
Behavioral Finance Investor Bias #1: People mistakenly think they — and the people they trust — are more skilled at something than they are.
This classic behavioral finance investor bias boils down to this: Despite the lack of relevant experience, some retirement plan fiduciaries may over-estimate their abilities when it comes to choosing the most appropriate funds for the plan. In addition to being over-confident about their own abilities, plan fiduciaries may also become positively predisposed to the skill level of their plan advisor, or their ability to choose one who’s suited to the task of adeptly picking investments for the plan.
Behavioral Finance Investor Bias #2: Too strong a focus on a single factor, ignoring other important information: When evaluating investment funds, there’s a lot of information to absorb. It can be overwhelming. In those instances, behavioral finance investor bias tells us that people tend to focus on one or two key pieces of information while ignoring other important factors. When it comes to choosing funds for your plan’s investment lineup, it’s critical to account for a multitude of factors, not just one. In fact, concentrating on just one factor, such as performance, is a poor fund selection method indeed. Investment funds are so much more than their past performance, and like every fund prospectus prominently states: “past performance is not an indicator of future results.” As such, it’s best to take a holistic approach to fund evaluation. There’s nothing inherently wrong with looking at cost or performance when evaluating funds for your plan, just remember to expand your focus to account for other key factors.
Behavioral Finance Investor Bias #3: Comparing apples to oranges: Not all investment funds are created equal, and each one plays a different role in your investment lineup. Thus, the metrics plan fiduciaries use to evaluate each fund should be different depending on a variety of criteria, such as asset class, style, risk profile, etc. At the end of the day, a plan’s investment lineup should be diverse enough to allow participants to maximize their portfolio allocation on an individual level. As such, fiduciaries should compare like funds with each other, and evaluate funds in different universes based on their own merits.
Behavioral Finance Investor Bias #4: Loss aversion causes people to fear risk: Loss aversion is a cognitive bias that commonly plagues investors. While a certain fear of risk is healthy, investors who see a repeated trend of losses begin to feel those losses more strongly, and thus, start to make irrational decisions based on fear. Loss aversion may not come into play when the plan’s investment lineup is initially established, but what happens when those investments go through a market downturn? What happens if that fear causes your employees to start making irrational decisions as they experience losses in their retirement plan accounts? What if they come to you with fears about volatility, or asking for more “stable” investments? How will you soothe participant fears? What if employees start to pull their money out of the plan, which could lead to compliance issues and fines? Plan fiduciaries should consider loss aversion and its resulting issues as they weigh their investment selection criteria and funds they choose.
Behavioral Finance Investor Bias #5: Placing too much importance on recent history: This behavioral finance investor bias refers to the tendency to weigh recent experiences or information more heavily than those that are further in the past. This “recency” bias is an issue when evaluating investment funds because again, placing too much emphasis on recent information, such as performance, managers or news can impact the ability to make a good decision. It always makes sense to conduct extensive due diligence during the fund selection process. This should include, a close look at the organization managing the fund family, the track record of success, as well as benchmarking statistics against their peer group. It also makes sense to review the specific team managing the fund and making certain the funds are being managed in line with industry requirements.
Plan fiduciaries have a responsibility to be aware of 401k behavioral finance investor biases, to understand them, as well as ensuring there are systems and processes in place to keep the investment selection process on an even keel. Of course, having a written investment policy statement (IPS) can help to keep behavioral finance investor bias in check. Benchmarking your plan’s investment options regularly is another way to objectively handle these 401k behavioral finance investor bias. Finally, maintaining frequent, open communication with your plan advisor can help keep 401k behavioral finance investor bias at bay and will help to ensure the funds are being chosen according to a rational and logical methodology.
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