There are lots of risks in retirement. Some you can’t control, like rate of returns and inflation. However, these risks aren’t the worst enemies of your retirement.
You know what is?
That’s right. You are your own potential worst enemy of your own retirement. Before you hit that back button and get back to reading the news thinking there’s no way you would sabotage your own retirement, let us explain in a quick minute.
Inside that smart brain of yours are wires that you sometimes just can’t control. It’s a growing field of study called “Behavioral Finance” that studies how biases, beliefs, and behaviors impact your investment performance.
Smart decisions vs. instinctive reactions
Economics Nobel Prize winner Daniel Kahneman’s 2011 best seller “Thinking, Fast and Slow” outlines three critical behavioral mistakes that trap investors like you into making poor decisions that cause poor investment performance.
A study of 35,000 households found that overconfidence caused investors to trade 67% more frequently, resulting in an underperformance of 1.4 percentage points per year over a five-year period. In a four-year study of trading activity on the Taiwan Stock Exchange it was found that, between commissions, taxes, and poor timing on buy and sell trades, investors lost an additional $32 billion that could have been saved were it not for excessive and unnecessary trading.
2. Losses sting more than gains please
Short-term portfolio volatility can cause reactionary decisions that are harmful to your long-term goals. It may feel comforting to flee the market to avoid the worst performing days. Studies show that those who do also miss the best performing days. Investors who remained fully invested throughout a 20-year period from 1994 to 2013 earned an annualized return of 9.2%. However, when just five of the best-performing days in the 20-year period (5,000 trading days), were missed, the return fell to 7%. Investors who missed 20 of the best performing days generated a 3.02% annualized return, and so on, until returns turn negative when more best-performing days are missed.
3. Confirmation bias.
Limiting conversations about investing to people that agree with your own way of thinking makes it less likely you will consider new evidence and make fact-based decisions. It can also lead to a herd mentality that can drive investors in one direction or the other while viewing the market in their rearview mirror. Buying stocks when they are popular, or selling them when everyone else is selling, almost guarantees underperformance. A good fee-only financial advisor will often challenge your preconceived notions about investments, which can result in better decision-making.
There can be many factors that differentiate successful and unsuccessful investors, but as one of the most successful investors of all time, Ben Graham, once said,
“The investor’s chief problem – even his worst enemy – is likely to be himself.”
Absent a sound investment strategy guided by proven principles and practices, most people will succumb to haphazard decisions based on emotions and reactionary impulses.
So…do yourself a favor. Stay out of your own way. Let a professional financial advisor help you create a retirement and investment plan.