Executive Summary
Recent research on the reaction of investors to the 2008-2009 market downturn has confirmed an interesting tendency of investors that I have long believed - the better our returns, the more we're willing to save. Yet the irony is that theoretically, the better our returns, the LESS we need to save, because we'll have more growth from our investments. Nonetheless, if we don't account for this very human behavior about saving, we can end out with some disastrous financial planning advice.
The inspiration for today's blog post comes from a brief released by the Center for Retirement Research at Boston College, exploring how households responded to the economic and market downturn of 2008-2009, and how those responses changed in light of varying household characteristics.
What caught my eye from the research came in the section where the researchers examined the factors that impacted an individual's decision to save more in light of the market events. In reviewing their findings, the authors noted "Those who expect a higher than average return have about 7 percentage points higher probability of saving more than those expecting average returns."
Wait, what? Huh? Those who expect higher returns are more likely to save? Isn't that the opposite of what is "supposed" to happen according to classic financial planning projections? Higher rates of return are supposed to mean that you need to save less to achieve your goals, because you're earning a higher rate of return and will enjoy more growth! The biggest savings requirements are supposed to be associated with low returns, where you need to save more to "make up" for the fact that you won't have very much growth!
Yet the "financial" approach - the less we earn, the more we need to save - runs counter to our typical behavior - the more we earn, the better it feels, and the more we save. Simply put, seeing our investments earn good returns gives us the positive behavioral feedback that supports our saving behavior. While it might be nice to hope that clients will save for the sake of saving, and for their future goals, we increasingly see that behavior change requires nearer-term feedback, and the best near-term feedback we can get is the growth that we enjoy on the savings we've made. Accordingly, positive growth becomes the positive feedback we need to perpetuate savings. That why studies regularly show that people stop saving and stop contributing to their 401(k) plans in market downturns, despite the fact that - again - the financial perspective would imply that we should do the opposite.
Perhaps what is of greatest concern to me, though, isn't just the fact that positive (negative) returns become a reward (punishment) for our saving behavior - it's that we can do some real damage to our clients if we fail to account for this up front. In point of fact, this particular tendency of human behavior is why I am so strongly against the common financial planning wisdom "the younger you are (and the longer the time horizon), the more aggressive you should be with your investments." Not only is that problematic advice because longer time horizons can actually increase the uncertainty of cumulative stock returns - as I explored extensively in the May 2010 issue of The Kitces Report - but more directly, taking very aggressive portfolio positions creates a virtual certainty that at some point, the portfolio is going to experience significant losses. While we may believe that such losses are only temporary and that the portfolio can/will recover, we may materially and permanently damage our client's psyche and savings behavior even if the portfolio does recover!
Accordingly, I have always been a strong advocate that a client's risk tolerance must be the driving factor in determining someone's maximum exposure to investment risk. Long time horizons may be an appropriate factor to encourage someone to invest up to their risk tolerance, but clients should never go beyond that comfort level. I don't care if you're 22 years old and you have a 70 year investment horizon until the end of your retirement; owning investments that are riskier than your comfort level is simply a recipe for disaster, even if you "have time to recover", as the inevitable downturn eventually comes and the dramatic losses destroy your willingness to save and invest. Who wants to save more when all you can do is look at your existing savings, the losses it has experienced, and think about how you could have enjoyed the money more by spending it instead of losing it investing!
This challenge - that investing beyond your risk tolerance can create a traumatic investment event that discourages future saving behaviors - is also why I was not a fan of the Ayres and Nalebuff investment philosophy that was in the news earlier this year. In their book Lifecycle Investing, Ayres and Nalebuff suggested that young investors should actually invest with margin leverage, to help their portfolios replicate the investment exposure in the early years that they will have in the later years when their portfolios are larger. Although I have some disagreement about their reliance on time diversification as well, my greatest concern in reading of their approach was the behavioral: the heavily margined young investor will, at some point, experience a very significant loss when the inevitable bear market shows up from time to time, but the event may be so traumatic to the investor that future saving and investing behavior will be permanent changed and scarred.
The bottom line is that as planners, we need to bear in mind that clients do have an emotional experience to investing, and that even if risky portfolios experience declines that turn out to be temporary, the adverse impact on client savings behaviors can be far longer lasting.
So what do you think? Do you witness this kind of behavior with your clients? Have you had a client where a traumatic market event caused them to permanently lose their willingness to save and take risk with investments? Would that client have been better served by a more conservative portfolio that may have required more saving or additional working years, but might have allowed a more steady path to success?
Any form of long-term projection is built on the back of assumptions. In the case of a retirement plan, there are several key factors, including portfolio composition (and assumed growth rates), inflation rates, savings, retirement spending, time horizon