Insights from Behavioral Finance Highlight the Value of Professionally Managed Investment Solutions

June 17, 2020 — Boston

Now may be an opportune time for retirement plan providers to revisit lessons from behavioral finance, which can offer insights into the thinking and decision-making of individual investors and help inform participant communications. Incorporating the expertise of a financial professional—whether through a pre-packaged or customized solution—can be a key first step for participants to combat the impact of potentially harmful human biases and improve financial outcomes for defined contribution (DC) plan participants, according to the latest Cerulli Edge—U.S. Retirement Edition.

Amid periods of market volatility and economic uncertainty, DC recordkeepers relate that most participants on their platforms are “staying the course.” While this may be the case, findings from participant transaction data nonetheless reveal increases in trading activity during 1Q 2020, with many of the redemptions resulting in reduction of equity exposure at seemingly inopportune times.

In July 2019, Charles Schwab, in partnership with the Investment Wealth Institute (IWI), retained Cerulli to study how advisors use and view behavioral finance when working with clients. Through a survey of more than 300 financial advisors, Cerulli finds the most pronounced emotional biases affecting the decision-making of advisors’ clients are loss aversion (26%) and inertia/status quo (23%). “Status quo bias, or inertia, is particularly acute in the DC space, in which many participants may be disengaged from their retirement accounts for long periods of time,” says senior analyst Shawn O’Brien. “As a result, participants may remain in portfolios with risk profiles that are not suitable to their current circumstances.” Although the expansion of auto-enrollment features, target-date funds, and plan re-enrollments has likely mitigated some of the effects of inertia, a large portion of 401(k) participants remain self-directed investors.

Self-directed investors may be more prone to certain behavioral biases, including inertia, than participants in professionally managed solutions. Simply choosing to self-direct 401(k) investments may, in certain cases, be a symptom of overconfidence bias. Cerulli finds that more than half of active 401(k) participants prefer to conduct their own investment research, either making the final investment decisions on their own (28%) or with assurance from a financial professional (24%). Less than one-quarter (24%) prefer to have someone else selecting their investments and only 11% desire a single investment they do not have to think about (e.g., a target-date fund).

Illustrations and short case studies demonstrating the specific ways in which thinking may be biased, and how these biases can negatively impact financial outcomes, are key to helping participants comprehend and appreciate the value of professionally managed solutions. Additionally, some managed account providers may be equipped to help participants identify and mitigate behavioral biases at an individual level. “By striving to understand the emotional and cognitive tendencies unique to the individual, advisors in managed accounts may help participants better prioritize their long-term goals, reduce short-term emotional decision-making, and achieve superior long-term financial outcomes,” adds O’Brien.

Note to editors

These findings and more are from The Cerulli Edge—U.S. Retirement Edition, 2Q 2020 Issue.

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