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November 28, 2011 at 07:38 AM
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.
