Why Financial Literacy Doesn’t Guarantee Good Decisions

Stay on track with your retirement planning. How emotional discipline could improve your investing decisions.

Ask folks how to stay healthy, and they’ll probably reply, “Eat right and exercise often.” This is sound advice, and everyone knows it. Ask the same people whether they live out this advice, however, and you might see some hemming and hawing. Despite our best intentions, we often struggle to turn good ideas into reality—sleeping in is more appealing than that sunrise jog, and just-this-once desserts pile up. The same problem plagues many in their retirement investing: Many investors get, for example, that diversifying their retirement portfolio is good and staying patient is better, but as a recent article by MarketWatch’s Chuck Jaffe discusses, knowledge just isn’t enough. Without discipline, awareness falls short.

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Simple Mistakes Are Common

Jaffe asked several finance experts to name their biggest financial mistakes. Many might expect experts to give answers like, “doing something esoteric like swapping derivatives contracts or day-trading, or something excessively risky like trading penny stocks”—complex activities befitting their expertise. But the replies dealt with fundamental, widely known errors like these:

  • Waiting too long to start saving
  • Living beyond their means
  • Neglecting to diversify portfolios
  • Piling into hot mutual funds at just the wrong time

Crucially, as the author notes, “most of these people recognized that they weren’t making optimal decisions, even as they made them and then let their subpar behaviors continue.”

Financial literacy presumably wasn’t lacking here: Any of the respondents could probably explain easily why each of those decisions was unwise and what they should have done differently. A shortage of discipline, however, led to mistakes.

Keeping Your Emotions in Check: Critical, But Difficult

For folks following a clear retirement planning strategy, this is a cautionary tale. A firm grasp of basic investing principles is important, even essential, but emotions like fear and greed too often loosen that grasp just when we need it most. Maybe you know diversification across companies, sectors and countries is crucial to managing risk in your portfolio, but when hot trends beckon, it’s tough not to leap at the chance of outsized returns. You probably know spending wisely is key to making your money last, but that new condo in Miami looks awfully inviting. Investors are told in every investment communication ever written that past performance isn’t indicative of future results, yet most investors start their due diligence by looking at past returns. Similarly, many allow their market outlook to be skewed by the recent past.

For some, this is an issue of knowledge. But for others, it’s the other half of the battle: They know—and yet acting on that knowledge is still a challenge. The spirit is willing, but the investor is weak.

The Toll of “Psychological Factors”

Observing when the average investor buys and sells stock is a good way to see this tendency in action. The goal, as the adage goes, is to buy low and sell high, but unfortunately investors are more likely to do the opposite. According to DALBAR, a market research firm, equity mutual fund investors hold their investments for an average of only four years—not nearly long enough to capture stocks’ longer-term gains. This short holding period contributes to investors enjoying only about half the return of broader markets.

Most tellingly, the study concludes “psychological factors” are primarily responsible for the gap, as emotional decisions lead investors to hop in and out of funds—and markets as a whole—based on recent performance. The pattern held true for early-2016 volatility as well: According to an Investment Company Institute report, equity funds posted an inflow of $7.49 billion in February, compared with an outflow of $4.97 billion in January. This coincides with the market’s steep fall in January (as part of a longer pullback), followed by February’s sharp rebound. Recency bias—the tendency to extrapolate recent trends into the future—appears alive and well.

Now, these data aren’t perfect—they tell us money left equity mutual funds in January, for example, but not where it went instead. Investors could have been moving to equity ETFs or individual stocks, maintaining their market exposure but changing its form. But in our experience, this likely doesn’t explain the lion’s share. Investors, like everyone else, often change their behavior and expectations based on recent events. The emotional reward—decreasing the painful pangs of loss—is real in the here-and-now. The potential negative financial consequences are more distant, and it is easy to rationalize actions based on painful loss. Maintaining mental discipline is just that difficult.

Perhaps Your Biggest Challenge: You’re Human

Investing can be challenging on many levels. Yes, there are technical challenges, like determining an asset allocation likely to reach your goals, selecting securities, maintaining a portfolio over time and more. But perhaps the biggest is we’re all human, subject to pangs of fear and greed. An adviser who counsels you wisely against falling prey to your own humanity can add enormous value.

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This guide addresses some key questions many face when planning for retirement.

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