First, let’s define behavioral finance. It is a field of study that focuses on psychological factors that influence investors’ decisions in financial markets based upon how they interpret and act upon specific information. This blog will focus on two types of behavioral bias, loss aversion and mental accounting and how a counterbalance between them can be a capital management strategy while in the pursuit of better outcomes that leads to less stress, anxiety and poor decision-making during periods of market turmoil.
Loss aversion is an emotional bias toward avoiding losses over seeking gains that can cause investors to actually take too little risk. This approach can lead to an underperforming investment portfolio that fails to keep up with inflation, provide a desired level of income or achieve other desired long-term goals.
An example would be a portfolio light on asset classes like stocks or real estate which tend to out-perform other asset classes (e.g., bonds and savings accounts) over longer periods of time but be more volatile and actually lose value at different points during the period being measured. The impact can be the investor being so concerned they will need funds from their portfolio during a down period in the stock market thus causing them to have to sell and realize a loss that they avoid the opportunity for longer term gains altogether.
Mental accounting refers to the behavioral bias whereby people view or treat money differently depending upon where it came from, what they think it should be used for or when they think they may need to use it. While this bias can have negative repercussions at times, it can also be an excellent antidote for the loss aversion bias when implemented within a “bucket strategy” in retirement.
There is no one approach to a bucket strategy as the strategy can be personalized to each individual but basically this concept allocates capital by either assigned utilization timelines and/or purposes. Nearer term uses (i.e., creating income for next five years) or specific purposes (e.g., emergency fund) are allocated more conservatively while longer term timelines (e.g., income creation in 10+ years) can be invested more aggressively regardless of age.
Below is an overarching example of bucketing that has proven effective within our clientele.
Jeff Acheson CPWA®, CFP®, CPFA™, AIF®, CEPA® draws upon his extensive experience, credentialed expertise and expansive relationships to provide perspective on a myriad of topics that impact the pursuit of financial independence.