Anchoring and Your Retirement Savings Strategy
“Anchoring” is a term that is used in behavioral finance. It’s the idea that things tend to get stuck in our minds, whereby we use irrelevant information as a reference point for evaluating some other piece of information or data. For example, if the market is up 20%, and your investments are only up 10%, you’re apt to be disappointed. That’s because your mind is anchored at the “20%” mark. Of course, here’s the lesson. If the markets are down 10% and your investments are up 10%, you’re likely to be happy. In both cases you’re up the same amount, but your emotions are exactly the opposite because you are relying on overall market performance as your “anchor”. Anchoring is hard to detect, hard to measure, and can lead to all kinds of issues when it comes to finances, and especially your retirement savings and investment strategy.
In the world of 401(k) plans, all too often we see anchoring occur, and not in a good way. The classic example is the “set it and forget it” mentality that many participants use in a potentially harmful way. Before the advent of auto enrollment and target date funds, many participants “picked” a salary deferral rate and “picked” one or more investment funds without much strategic thought, inadvertently establishing “anchors” through which they might evaluate future fluctuations in their 401(k) accounts. While things tended to go well for a while, at some point many participants experienced a rude awakening during a market decline. In many cases the trauma of the market event caused them to overreact and make another poor strategic move which, in many cases, resulted in the participant taking big losses by selling their investments to “protect” from more downside losses. The end result was that they typically sold low and later on bought back the same investments at higher prices. This is the exact opposite of what can help your portfolio most over the long-term, which is to buy low and sell high.
One way to get around an “anchoring” issue is to use your 401(k) plan features to your advantage. Participants should take advantage of tools like auto enrollment, auto escalation of contributions and target date or managed funds—all of which can make saving simpler for participants and help them potentially avoid psychological pitfalls such as anchoring that can sabotage sound investment practices. One other key to a good savings and investment strategy is to refrain from overreacting when market events occurs.
Anchoring occurs in a good way when participants “stay the course” during market turmoil. A good long-term strategic approach is to be comfortable with the level of risk you take and to have the confidence to know that during market declines, your contributions can benefit from the concept of dollar cost averaging, which over time can result in buying low and selling later on at higher prices.
Most importantly, participants should know their limits, understand the risk/return profiles of various asset classes and stick to their long-term objectives in saving for retirement. True hands-on investment management can take a lot of time and dedication to do things properly, and even professional money managers often get it wrong. If you don’t have the time or inclination to be hands-on with the management of your 401(k) plan, use the tools available in your plan to help set you up for better long term results.
We encourage participants to take advantage of our SmartPathTM series to help set a course for retirement readiness and stay on track.
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