It’s easy to imagine that investment success necessarily follows from having a good understanding of investments. Knowledge helps a lot of course. But it’s easy to forget the role of psychology. If we’re investing a small amount, we might not be particularly emotionally invested. But when we’re dealing with our retirement portfolio, the ups and downs will affect our emotions. Understanding our own psychology is just as important as understanding investments.
Retirement planning has three main phases:
- Our working years.
- Transition into retirement.
- Retirement itself.
The psychology of saving for retirement
During our working years we’re hopefully earning enough to save towards our retirement. Auto-enrolment should help, but it requires a conscious decision to save more than the minimum. Jam today often seems more attractive than jam tomorrow. Getting the balance right is part science, but also part psychology. Some of us are born savers, whereas others are born spenders, with a whole spectrum in between.
Once we’ve committed to saving for retirement, we then face decisions about where to invest our savings. This is where the psychology of risk comes in. It’s important to understand our personal risk tolerance.
If we’re investing part of our monthly paycheck into a fund, we’re hopefully benefiting from pound-cost averaging. By automating the investment process, we’re less likely to worry about what the market is doing in the short term.
Occasionally we might come into a lump sum that we need to invest. If we try to time the market, we risk mistiming it. Some people choose to split such investments into several monthly instalments on fixed dates, which can provide the psychological cushion of pound-cost averaging.
Transition into retirement
As we approach retirement, having a plan can be helpful. If we don’t, then we’re relying on pure guesswork. A plan may include decisions about how much, if any, guaranteed income to aim for. Some of this will be provided by the state. If we’re fortunate some may come from defined benefit pensions. Some may need to come from buying annuities.
If guaranteed income is not enough to cover spending, many retirees draw down from investments to make up the difference. And with low annuity rates, this is a common scenario.
Planning to buy an annuity and planning for drawdown are quite different. An annuity used to be the norm. Planning to buy one involves gradually de-risking investments up to the point of retirement. This is sometimes known as the glide-path to retirement.
But the glide‑path approach may be less suited to drawdown planning. Taking away risk means taking away growth prospects. The point about drawdown is that it needs to last throughout retirement; it typically relies on investment growth to reduce the risk of early depletion.
The role of a retiree’s psychology is crucial. To some, nothing short of a guaranteed income will do, even if that means drastically cutting spending. For others, higher spending will be the primary goal, even if that risks future ruin. Most of us fall between these two extremes.
The psychology of retirement drawdown
Once we’re past the transition, chances are our spending will depend on a combination of guaranteed income and drawdown. The bigger the drawdown portion, the more uncertain we’ll be about sustainability. If markets are kind to us, our investments will grow faster than our drawdown rate. Or they may fall in value, potentially causing us stress and worry. So psychology continues to play a role in how we manage our investments, to balance risk with reward.
A widely used approach for easing the psychological strain of drawdown is the bucket strategy. With this approach, we fund our day-to-day spending from a sizeable cash reserve ‘bucket’. We replenish the cash reserve by transferring income or assets from a medium risk bucket. In turn, we replenish the medium risk bucket from a high-risk bucket of long term investments. Using this approach doesn’t eliminate the risk, but aims to shield our psyche from it.
Know thyself
An important part of financial decision‑making is recognising the role of our own psychology. Of course this won’t be fixed for life. An investment choice that feels comfortable in our 20s may feel very different in our 70s.
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