You’ve often wondered what your clients are thinking when they flee the stock market after a downturn. However, according to Prudential research, it’s not what they’re thinking that may be most important, but what they’re feeling.
Behavioral Risk in The Retirement Red Zone, a 2007 study commissioned by Prudential Annuities, revealed that 3 out of 4 Americans were influenced by their emotions to a high or moderate degree when making retirement investment decisions. These decisions may not be in their best interests–and may weaken their financial security in retirement.
It’s all about the uncertainty. The study paints a vivid picture of how emotions affect investors in what Prudential calls The Retirement Red Zone, the crucial 5 years before and after they retire. Many investors worry about outliving their retirement savings (longevity risk). But, they also worry about a sudden or dramatic downturn in the market when they can least afford it (sequence risk). And the more they worry, the more likely emotions can emerge that may impact their decisions and derail their retirement plan (behavioral risk).
How do you know which of your prospects or clients are most susceptible to emotional decision-making; which emotions will affect them most; and if there’s a way to mitigate this risk? Prudential’s research provides some answers.
Defining an investor’s Retirement EQ
Conducted in partnership with behavioral finance researchers at the University of Connecticut School of Business, the study defined the emotional landscape underlying the investment decisions of Americans in The Retirement Red Zone. It also sparked the creation of investor-facing tools that can help financial professionals address behavioral risk with their clients. One tool can even estimate the likelihood that an investor will be influenced by a particular emotion.
So let’s take a closer look at the study. The UCONN team, led by Dr. V Kumar, devised a 12-item questionnaire asking 1,000 Americans to describe the actions they’d take under various scenarios. Data analysis revealed 5 emotions influencing investment decisions, as well as the level of influence. This allowed us to produce a Retirement Emotion Quotient (or EQ) for each individual in the study.
The study revealed that the EQ of the participants ranged from a low of 15 to a high of 57, with a mean score of 34 (see chart A). Bottom line: while everyone was influenced by their emotions to one degree or another, 20% were influenced by a high degree and over half by a moderate degree.
What specific emotions (or tendencies) affect Americans in The Retirement Red Zone? The research identified 5: fear, regret, inertia, aggressiveness and susceptibility (to a friend or relative’s advice). (See Chart B.)
As you can see, of these 5 emotions, fear and regret were the most prominent. Almost 3 out of 4 investors were influenced by a moderate to high degree of fear when making decisions. And 8 in 10 investors were influenced by feelings of regret.
Since fearful clients usually prefer certainty and wish to avoid losses, it can prevent them from taking measured investment risks to achieve their retirement goals. Similarly, clients who feel regret about past investment results may avoid decisions they think might lead to further regret.