6 Biases That Can Disrupt Retirement

Overconfidence is perhaps a familiar idea and applies when someone overestimates their knowledge and abilities. 

What can make overconfidence especially pernicious for retirees is that we often assume we keep full command of our faculties even as normal age-related cognitive decline weakens our attention span, ability to multitask, word recall, and the amount of information we can remember. This can be challenging, especially if we aren't aware of such changes. 

How to mitigate this bias: Retirees and near-retirees may not recognize changes in their decision-making powers as they age, so it can make sense to identify a trusted outsider who can be brought in to help. This can mean choosing a trusted contact for financial accounts, assigning powers of attorney consistent with one's estate plan, or working with a trusted advisor, either to directly manage one's financial assets or as a sounding board for important financial decisions.

Loss aversion makes us overly sensitive to potential losses relative to opportunities for gains. Although this bias can affect anyone, loss aversion tends to increase with age. 

Of course, there can be good reasons to become more sensitive to losses as we age. Older investors have less time to recover from a loss than younger investors. A major drop in the early years of retirement can permanently undermine a portfolio due to sequence of returns risk. The idea is that selling assets as they're losing value means having to sell more investments to raise a set amount of cash. Not only does that drain one's savings more quickly, but it also leaves them with fewer assets to generate growth during potential future recoveries. Then there's longevity risk, or the risk of outliving one's money.

However, problems can arise when we become so sensitive to potential losses that we undermine our portfolios. This is especially true for investors who grow overly conservative before they have adequate savings, robbing themselves of the growth potential they might need to support their lifestyles. It's important to find a balance between preserving wealth and growing it over a long retirement (and potentially leaving a legacy).

How to mitigate this bias: One way to deal with loss aversion is to build walls between your spending assets and your growth assets. It helps to create a short-term reserve—comprising cash, cash equivalents, CDs, and short-term bonds—equal to two to four years of your retirement spending needs, which you can use to cover expenses. 

Another approach to consider would be covering essential retirement expenses with an annuity offering some form of income guarantee (dependent upon the insurer's ongoing ability to pay, of course). 

The bottom line is that knowing your essentials are covered by a cash reserve and potentially a guaranteed income stream, might make you feel more secure investing the rest of your portfolio for potential growth.

The endowment effect, often described as a byproduct of loss aversion, can lead people to overvalue objects or investments they already possess relative to those they don't. This might make you reluctant to sell even investments whose prospects have dimmed.

This bias can pop up among investors with large, concentrated positions in particular stocks. For example, long-time employees of a company could have large stock holdings they are reluctant to sell, perhaps because they're more sanguine on its prospects than the markets are. Or investors who got in on the ground floor with a stock investment that subsequently skyrocketed might keep that position merely because it reminds them of a past success. 

However, letting any single investment grow to account for a large share of your portfolio can be risky. What if the company falls out of favor with the markets? Overconcentration can also make for difficult tax situations if you have a lot of unrealized gains. 

The real test for such holdings isn't how they did in the past, but whether you would consider buying it today. If you already have a large position in a stock or the price of that stock is so high you wouldn't consider buying it today, then it's worth taking a closer look at your portfolio. 

How to mitigate this bias: It can help to remember that investments are simply a tool for achieving life and financial goals, not a repository of sentiment. You can cap your holdings of company stock at no more than 10% of your portfolio without compromising your loyalty. The remaining 90% should be invested with an eye toward diversity and tax-efficiency, in line with your risk capacity and tolerance.

Anchoring bias and the availability heuristic are both related to how we use—and misuse—information when making decisions. Anchoring is when we fixate on the first data point we receive when making decisions, regardless of whether that point is relevant to our needs. For example, imagine we saw a watch marked down from $2,000 to a "special" price of $1,000. Using $2,000 as our reference point might make $1,000 seem like a great deal, but what if another shop sells the same watch for $500? What if a $200 watch would suit us better? You can see how orienting ourselves around the $2,000 starting point could lead us astray. 

The availability heuristic is a mental shortcut in which information that happens to be top of mind overly influences our decisions. For example, if the stock market recently plunged, some investors may become reluctant to buy assets because they're more focused on that memorable rough patch than on making a dispassionate assessment of the market's future prospects. 

Fixating on certain data points can negatively influence our retirement decisions in a few ways. 

The best start date for retirement is one. The appropriate date for each person is different, but people may be tempted to allow particular ages to influence or even dictate their plans. To be sure, some retirement milestones occur at specific ages. For example, 62 is the earliest age for claiming Social Security benefits, and 65 is when someone can first apply for Medicare. But those milestones shouldn't force someone to work—or save—less or longer than they want. 

Mental shortcuts can sabotage our plans in other ways. For example, the 4% rule—which says you can withdraw 4% of your portfolio value in the first year of retirement, then adjust subsequent annual withdrawals for inflation, and your portfolio will last 30 years—is a popular rule of thumb for thinking about retirement withdrawals. This may be too rigid, though. The 4% rule doesn't account for your personal circumstances, your ability to adjust spending as needed, or the fact that many retirees just don't think about withdrawals this way. Adhering too rigorously to a rule of thumb could potentially prevent you from living a fulfilling retirement when that money matters the most.

How to mitigate these biases: In short, start by recognizing that retirement is too personal a situation to be dictated by common milestones or rules of thumb. These planning shortcuts may not be appropriate for you and could even prevent you from enjoying the next chapter of your life. Your age, savings, and goals should be embodied in a personalized plan aimed at giving you the life you want.

This refers to when investors copy what others are doing—like piling into a hot stock or cryptocurrency during an upswing—because of some fear of missing out on quick or easy gains. People who are behind on their retirement savings may be especially susceptible to visions of grabbing a quick buck.

Aggressively chasing trends when everyone else is doing the same can expose you to the risk of buying high and then getting hit with a sharp reversal, though. 

In short, news headlines and the "vibe" among investors aren't good benchmarks for your own needs or performance. 

How to mitigate this bias: Any time you start benchmarking financial decisions against what friends or family are doing, it's time to be on guard against herd mentality. Make sure your financial and investing decisions serve your goals—preferably as they're expressed in a detailed plan—and if you do decide to dabble in a hot part of the market, consider limiting your investment to what you can afford to lose without impacting your retirement. 

All investors are susceptible to common behavioral biases—it's part of being human. 

That's one reason we believe everyone, regardless of their age or amount of assets, can benefit from drafting a plan. 

A financial plan can help investors transitioning to retirement determine an appropriate mix of assets that aligns with their goals, time horizon, retirement income sources, and investment preferences. 

A plan can also help keep you on track even when a gut feeling, rule of thumb or reasonable-seeming mental shortcut offers up an easy answer.