We are finally starting to see a growing emphasis on developing investment strategies and approaches that best suit retirees, rather than a “one-size-fits-all” approach.
After all, it is obvious that retirees – who are no longer putting money into savings and who must live off what they have already accumulated – have very different needs to those who are still working and contributing to their super, and have perhaps decades in which to ride out any market downturns.
The way that retirees react to market downturns is particularly relevant here.
Retirees have been shown to be most likely to make decisions against their best financial interests, at the worst possible times. They may have long-term, well-crafted investment plans in place, but a market downturn can turn these plans into “impatient capital” overnight, with extremely damaging consequences.
Most of us have heard the story of a friend or relative who, driven by fear, moved to cash at the bottom of a market cycle.
This seemingly irrational behaviour is called cognitive bias – instinctive decision-making that is hard-wired into us at birth.
It was the focus of ground-breaking work by psychologists Daniel Kahneman and Amos Tversky, which has formed the bedrock of modern behavioural finance theory. Known as prospect theory, it can help us understand why humans tend to lack reason when it comes to financial decision-making.
At Wheelhouse, we believe an understanding of the triggers that lead people into irrational decisions can help in retirement strategy design.
By recognising these cognitive biases – and building retirement portfolios that take these biases into account – we believe retirees are better positioned to stick to their long-term plans and achieve their goals.
Advisers, too, know that a less stressful financial journey makes for a happier client/adviser relationship, where both parties benefit.
So, what is prospect theory?
In essence, it describes how people choose between different options (or prospects) and how they estimate (often in a biased or incorrect way) the perceived likelihood of each of these options. The theory was developed in the late 1970s as way of explaining real-world choices and how these can systematically override optimal decision-making in many situations, especially financial.
Before this, academics tended to rely on utility-based models, which represented human decision-making as rational. This was based in part on the view that investors would focus on the final wealth outcome, and rely on this as a key consideration in decision-making.
Prospect theory shows that in the real world, investors are more likely to prioritise gains or losses from a current reference point and treat these gains or losses differently from a value perspective.
Effectively, investors see the path of investment returns as more important than the final wealth destination.
Central to this is the concept of loss aversion where, for a given gain or loss, the perceived value is treated very differently. In other words, the pain felt from losing $100 is sharper than the joy of making $100.
There are a number of other pioneering conclusions to come out of prospect theory, some of which are outlined below.
Overweighting small probabilities
In their work, Tversky and Kahneman argued that people underweight the likelihood of large probability events and overweight small probability ones.
Insurance, for example, is a result of people agreeing to a smaller, certain loss (the premium paid) rather than risking a large expense. The perceived likelihood of a major health problem is greater than the actual probability of that event occurring. There’s a reason insurance companies are some of the oldest on the planet.
There is an extension to this bias, where people ascribe more weight or value to the complete elimination of a given risk, as opposed to an equivalent reduction in risk.
This principle is often evident in the pricing of insurance, where risk removal is priced differently to risk reduction (witness a high excess versus no excess, and the subsequent effect on an annual premium).
It is also often reflected in the pricing of many capital-protected type instruments.
Framing and mental accounting
Framing describes the tendency for people to use a reference point as the benchmark for comparisons. As mentioned, this is a key difference to utility-based models, which focused on final wealth outcomes.
In the following example, investors are given an initial sum of money and asked to choose between alternate scenarios. In either case the final wealth positions (total gains) are exactly the same across both scenarios.
Under utility theory, an investor should choose the same option in either scenario – but in reality this rarely happens. The starting point matters, as it determines the path to the final wealth destination.
In scenario one, investors are overwhelmingly more likely to accept a certain gain of $500 (risk-averse behaviour). However, when faced with relative losses, investors focus on minimising the sting of loss – even if this means the possibility of losing $1000 in order to deliver zero loss (risk-seeking behaviour).
When gains are being evaluated, ambiguity is penalised – but the preference for avoiding ambiguity is less established when facing the prospect of losses.
In other words, investors are assessing their path and altering the perceived risks according to their biases, as opposed to focusing on the final wealth attained (which is equivalent).
Mental accounting, like framing, describes how people have different “mental bank accounts” for different expenditures.
For example, people are more willing to pay for goods using a credit card than cash, even though they draw upon the same resource. Similar to prospect theory, people are unable to focus on the final wealth outcome, instead considering the individual transactions separately and once again focusing on the path of returns.
Diminishing marginal returns
Utility theory and prospect theory appear similar in that as wealth or gains increase, the marginal value or utility progressively declines.
In other words, the joy felt from a $1000 investment moving up to $1010 is less than the joy felt from a $100 investment moving up to $110. The absolute gain is the same, but clearly we value relative gains differently to absolute gains.
What does this mean for retirement planning?
We believe a sound understanding of prospect theory can assist advisers and investors to develop portfolios that align our behavioural biases with the path of asset class returns – and ultimately, investment outcomes.
By recognising the effect of these biases and incorporating it into a comprehensive investment plan, advisers can add value by increasing the likelihood that their clients stick to their long-term plans.
It therefore makes sense for investor portfolios to address the following.
- Loss aversion (via capital protection)
Losses are felt more acutely than gains, and – as the GFC proved – retirees are more likely to disinvest during market stresses than other age groups. This is compounded by the separate concept of sequencing risk, which can also impact on outcomes for retirees.
As such, capital protection is integral during periods of market weakness.
Note that this usually only comes at some cost of foregone investment returns (i.e. without risk there can be no return), and hence some approaches to capital protection can perversely increase risk as they simply increase the certainty of investment returns not delivering a portfolio’s objective.
The key is to improve the shape of returns to minimise drawdowns – delivering a growth profile with capital protection.
- Certainty effect (via higher income)
Investors value more certain returns above more ambiguous returns.
In an equity landscape, we believe this helps explain the typical Australian retail investor’s focus on distributions, where regular bank account deposits can unfortunately be prized more highly than the accompanying capital fluctuations in the unit price.
While there may be some comfort provided to retirees from regular payments, the more important metric is “total return,” which includes movements in the unit or share price alongside distributions.
Within this total return focus, income can play a critical role by providing: greater certainty, especially in low-growth environments when real returns are difficult to generate; and increased predictability, as the range of possible investment outcomes can be narrowed.
- Diminishing marginal returns (via a smoother return profile)
An investor’s sense of value diminishes as gains increase, so a gain from $100 to $110 is less meaningful than a gain from $50 to $60. In this way, underperformance in a strong positive market is less important to an investor’s sense of value, especially in relation to stronger performance in a lower growth or negative market.
We believe retirement portfolios that are constructed to deliver growth, but with a return profile that mirrors our humanistic biases and includes elements of loss aversion and income certainty, can result in an increased likelihood of adhering to long-term plans and thus achieving better outcomes.
From an adviser’s perspective, it should also be noted that this less stressful investment path may lead to a more rewarding and fulfilling client relationship – which is in everyone’s best interest.
Alastair MacLeod is managing director of Wheelhouse Partners, a boutique asset manager partner of Bennelong Funds Management.