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October 20, 2021 at 02:13 PM
What You Need to Know
- Investors are not always rational, contrary to common assumptions in economic theory.
- Retirees have a clear preference to not deplete wealth, largely due to an uncertain lifespan.
- Investing in equities for the long term may become attractive to income-focused investors as the relative dividend yield increases.
Investors are not always rational, contrary to common assumptions in economic theory. While this statement may seem obvious to financial advisors, this disconnect has led to a dearth of research exploring efficient strategies for “behavioral” investors (i.e., those with irrational preferences).
One example of an “irrational” preference would be for income, a goal that is especially common among retirees. In theory, a retiree (or investor) should be indifferent between liquidating capital and yield; however, retirees have a clear preference to not deplete wealth.
For example, a Society of Actuaries survey noted that only 17% of pre-retirees planned to spend down their wealth in retirement, while 32% planned to withdraw only earnings and leave principal intact.
When it comes to generating income, an investor theoretically should be indifferent between liquidating capital and yield, because they have similar effects on the value of a portfolio.
In reality, income-focused investors typically have a strong preference against selling down principal despite the potential inefficiency of the approach and implications on the available opportunity set of investments.
These investors also typically have a strong preference against purchasing an annuity, despite the fact annuitization is widely considered the most efficient approach for generating retirement income (and hedging longevity risk).
A potential behavioral justification for the desire to not spend down capital is an uncertain lifespan. There have been notable gains in longevity in the past few decades, especially among wealthier Americans, and leaving principal untouched is a potential approach to mentally manage an uncertain lifespan.
Additionally, leaving the principal untouched creates the possibility of a bequest.
Difficult Investment Choices
These are difficult times for those focused on income-producing investments, with yields on 10-year government bonds hovering around 1.5%.
While equities are generally considered prudent only for investors with a high risk tolerance and longer time horizon, given the notable price return volatility, to the extent an investor is able (and willing) to hold equities for the long term (e.g., five-plus years), they may become attractive to income-focused investors as the relative dividend yield increases.
