November 28, 2011

The Anchoring Effect: How to Save Investors From Inertia

Instead of protecting clients in rough waters, the anchoring effect prevents them from staying afloat

Although it has become much easier for individual investors to adjust their retirement accounts as often as they wish, human nature is such that most people are still inclined toward just leaving their allocations be, even if they know it’s probably not in their best interest to do so.

In fact, many people don’t even adjust their portfolios on an annual basis, says Victor Ricciardi, a professor of finance at Goucher College in Baltimore, Md., despite the fact that an increasing number of companies allow investors to automatically set up an annual rebalancing online.

Ricciardi—who has done extensive research in the fields of behavioral finance and the psychology of risk—attributes this lack of proactive investment behavior to what he calls “the anchoring effect.” The anchoring effect causes individuals to cling to a belief that may or may not be true, and to base their decisions for the future on that belief. The inertia and inattention that this leads to can have detrimental effects on their retirement accounts.

“In the late 1990s, for example, the stock market was going up and people simply followed suit and kept buying more and more shares,” Ricciardi says. “Even though that resulted in a bubble situation, investors’ general tendency was to just let things be without bothering to take any timely decisions with respect to asset allocation and risk—decisions that could have helped them fare better in the future, when the markets turned.”

If people anchor themselves to the idea that the stock market will keep going up, they not only will suffer from inertia, but will inevitably find themselves in a risk category that isn’t the right fit for them, and they’ll be putting themselves at a far greater risk when that market turns, Ricciardi says. Conversely, in a period of protracted market downturn, people tend to anchor themselves to the idea that stock prices are just going to keep going down. This then leads to a complete disregard for investing in the equity market (in fact, people start to shun stocks, Ricciardi says), and results in a situation where individuals end up in a risk category that’s well below what would benefit them in the future.

“What we’re seeing now is negative anchoring, a period in time where people are framing their investments in the context of the most recent financial crisis and all the negative news that they’re constantly getting about the economy, unemployment and so on,” Ricciardi says.

Human nature is such that people just don’t like to change, and that’s even more the case when it comes to money and investing, which are governed by a deep-set fear of loss.

“The idea of just letting things be, of not making timely decisions are common to most people in both positive and negative markets,” he says.

But the only way to counter the very common “status quo bias” that this results in, Ricciardi says, is to make sure that people are rebalancing their retirement portfolios on a regular basis, or at the very least once a year.

“This is the only way to counter the status quo bias and investor inertia, and to make sure that people are not in a risk category that doesn’t fit them or invested in something that doesn’t benefit them,” he says.

And the only way that people are going to actually rebalance annually is by working with a financial advisor, whose job it is to make them rebalance and to take both the subjective and objective sides of saving and investing into account and help their clients become better financial decision makers, Ricciardi says.

“Financial advisors have to monitor their clients and make sure they rebalance on an annual basis,” he says. “People go to a doctor every year, they do their taxes every year. They should also be looking at their retirement portfolios every year and it’s their advisor who has to get them to do this.”

An advisor also needs to determine what kinds of mental biases are affecting their clients’ investing behavior and understand how to counter these, if necessary, for more efficient financial planning, Ricciardi says. And then, advisors need to figure out what are the best products suited to their clients’ risk profile and ensure they’re properly diversified between asset classes and not staying away from any particular product.

“The whole idea is that people should not have an emotional attachment to their investments,” Ricciardi says. “Advisors need to help their clients with their mental biases and then try and implement a non-emotional investment strategy.”

Page 2 of 2
Single page view Reprints Discuss this story
This is where the comments go.