Behavioral investment pitfalls can have a significant impact on investment returns for the average investor. The impact can be anywhere from 0.5% to 1.0%+ per year. But that’s the average impact on the average investor. The reality is that this impact will manifest differently for each investor and it could be years or even decades before an individual investor gets trapped by one of these behavioral pitfalls.
An average impact of 0.5% to 1.0% makes it sound like this happens every year. While this is true on average, it actually reflects many different experiences for many individual investors.
The truth is that some investors will experience no behavioral impact on their investment return for years and years before suddenly experiencing a negative effect. The AVERAGE impact of 0.5% to 1.0% means that in a given year some people experience no impact and others experience a small or large impact.
The problem is that this can lead investors into a false sense of security. It can make it seem like everything is going well until suddenly it’s not.
In this post we’ll provide three examples of how behavioral investment pitfalls can actually manifest in an investor’s portfolio and how they impact long-term investment returns.
Compounding interest is a beautiful thing. It’s like magic. Give it enough time and compounding interest can turn even the smallest amount of money into millions.
Investing CAN be as easy as that, just set it and forget it. But when it comes to investing, we’re our own worst enemy.
Without guidance, rules, plans, checks and balances, we as individuals can cause some serious damage to our investment portfolios. We’re biased in many different ways and those biases create many behavioral investing pitfalls to watch out for.
There are many different behavioral investing pitfalls to be aware of, but some are more common than others (especially now that investing is even more easy and accessible). Some can be reduced with new investment options that automatically rebalance but there is still a risk.
Are you currently making one of these three behavioral investing mistakes?!?
One of the most important pieces of a financial plan is income. Without an income it’s simply impossible to achieve any financial goals. Plus, having a higher income makes financial goals significantly easier to achieve.
While expenses often get a lot of focus because they’re entirely within our control, the fact is that without a certain level of household income it becomes much harder to save, invest, and still cover monthly spending.
This is why income, and specifically how income changes, should be an important part of every financial plan. Increasing income over time will make financial goals significantly easier to achieve, it makes debt payments a smaller proportion of net income, and it makes it possible to juggle competing priorities.
But unlike spending, income is unfortunately not completely within our control.
Increasing your annual income can be done a number of different ways. There are “side hustles”, there are second jobs, there is semi-passive income from rental properties etc. etc.
But the best and easiest way to increase income is to get paid more for what you’re already doing. You’re already at work, why not get paid more for doing the same thing?!? No “side hustle” required. No extra work. No stress of rental properties and bad tenants.
Increasing income is quite common, especially in a persons early 20’s and 30’s. On average income increases 7% per year during this phase. Once we reach our 40’s the pace of increases starts to slow down but those 15-20 years of steady increases can make a big difference.
How do you get salary increases of 7% per year (on average)? It takes a few things to make it easier, negotiating your salary is one, and unfortunately, switching employers often is another.
How impactful is increasing your income? Massive. In our example below, over a person’s working career, it’s equal to about $585,000 or 20,000 hours of extra work.
So, what would you prefer? Negotiating your salary every few years? Or putting in an extra 20,000 hours work (or about 10 years!)
Financial Independence Retire Early (aka FIRE) is one of those big personal finance goals that has gotten a lot of attention recently. The idea of being financially independent, choosing when and if to work, is attractive for many people, especially when there is so much uncertainty in the world.
To be financially independent means that your investments (whether that be stocks, bonds, GICs, real estate etc) can provide enough income to cover annual expenses indefinitely. FIRE enthusiasts typically use the 4% rule as a guideline for how much income they can generate from their portfolio each year. The idea being that a person can draw 4% of their initial portfolio balance, adjusted for inflation each year, and have reasonably high chance of not running out of money after 30-years.
By using the 4% rule we can generate a rough target for FIRE. The basic idea is that you can take your annual expenses and multiply by 25 and that is your “FIRE number“. This is the amount needed in investments to safely retire early (although with low interest rates and low bond returns at the moment this rule is often thought to be too risky).
But despite it being a simple concept, reaching FIRE is a difficult task. It requires a high savings rate, low expenses, and lots of time.
FIRE is made easier with an above average income, which allows for a higher savings rate, but it is still a difficult task. Reaching FIRE means living well below your means for an extended period of time.
This combination of low spending, high savings, and a long time frame can lead to what’s known as “the boring middle”.
In this post we’ll briefly explain what FIRE is, why it’s so easy in the beginning, and why “the boring middle” could be a sign that there is an imbalance in the plan, one where the means may not justify the end.
Can you retire when the stock market is at an all time high? For many soon-to-be retirees this is an important question. It can be extremely nerve-racking to “pull the plug” and leave a stable income when investment values are at their peak.
But is this really a concern? Is it bad to retire when markets are at an all time high?
For many soon-to-be retirees, their investment portfolio will make up an important part of their future retirement income. Even retirees with a pension or full CPP/OAS will often have a small investment portfolio to support additional spending in retirement.
Many retirees worry about retiring at an all time high. They worry about a large decline in investment values soon after retirement. They believe this will dramatically impact their retirement plan. But is this concern justified? Or is this one of those biases that we’re all susceptible to?
Working for a few additional years would certainly help solidify a soon-to-be retirees financial plan, but at what cost? That lost time can never be recovered and could represent some “prime retirement years”. That income may also never be needed if everything goes to plan.
As it turns out, we’re actually at an all time high quite often, and the impact of retiring at an all time high isn’t even close to what we’d assume…
The 4% Rule is a common personal finance rule. It suggests that a retiree can spend 4% of their initial retirement portfolio each year, adjusted for inflation, and have a reasonably high chance of success.
When talking about the 4% Rule, a retirement period is considered a “success” when the retiree doesn’t run out of money by the end of retirement. Any investment balance above $0 is considered as success, even if that’s just $1.
By using this safe withdrawal rate, the success rate of a retirement plan could be as high 90%-95%+. This means that during 5%-10% of historical periods a retiree could run out of money if faced with the same sequence of returns in the future.
But… this also means that during 90%-95% of historical periods a retiree will end up with money left over, sometimes a lot of money.
This is the unspoken downside of the 4% Rule. By aiming for a high success rate of 90%-95% we’re often building plans for the very worst-case scenarios. By using the 4% Rule we’re planning for a very poor sequence of returns in early retirement, we’re planning for below average returns for 5, 10, 15+ year periods, or we’re planning for high inflation that is significantly above the average.
But what happens if we get average returns, average inflation, and steady growth year over year… well… we could die with millions in the bank.
No one wants to be “the richest person in the graveyard”, so what can be done about the fact that 90%-95% of the time the 4% Rule will leave us with lots and lots of money in late retirement?
There are a couple options to consider but first, let’s look at the typical “success rate” analysis that we do in a retirement plan and what “success” actually means.