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 need to decide where to invest our savings. This is where the psychology of risk comes in. It’s essential 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. Instead consider splitting the investment into several monthly instalments on fixed dates. This provides the psychological cushion of pound-cost averaging.
Transition into retirement
As we approach retirement, it’s essential that we follow a plan. If we don’t, then we’re relying on pure guesswork. Our plan should include deciding how much, if any, guaranteed income we’re going to aim to generate. 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 our guaranteed income is not enough to pay for our spending, then we’ll also need to draw down on our investments. And with currently historically low annuity rates, this is quite likely.
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 when planning for drawdown, the glide-path approach doesn’t work so well. Taking away risk means taking away growth prospects. The point about drawdown is that it needs to last throughout retirement; and this requires growth to avoid early depletion of funds.
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.
One of the best approaches to give us a psychological crutch 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
A necessary step in making good financial decisions is to take our own psychology into account. Of course this won’t be fixed for life. A good investment decision in our 20s might be wholly inappropriate for our future self in our 70s.
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