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February 2006 Personal Finance:
Investing for Retirement
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Mary Wilson knows more about money than the average person. Since receiving her MBA from the Graduate School of Business in 1993, she has held several senior positions in finance, most recently serving as the chief financial officer of Fremont Partners in San Francisco. Yet overseeing the financial operations of a diversified investment fund did not prepare Wilson for the challenges of planning for her own financial future.
Two years ago, when she was about to give birth to her third child, Wilson stopped working outside of the home and resolved, along with being a full-time mom, to get the family’s savings in order. There were so many different 401(k) accounts from various jobs she and her husband, John, had held over the years that Wilson did not even know what their total assets were. Realizing that the best chance of maximizing returns was to have a unified approach to investing, she set about consolidating the assets. Two years later, she is still not finished. Every past employer seemed to have its own set of procedures for transferring funds, and half the time Wilson could not even get a live person on the phone to explain the rules. “For the longest time—about 10 years—I just left all of my 401(k) money in a lot of different accounts,” she says today. “I know it’s lame and pathetic, but I just didn’t have the bandwidth to deal with it.”
Wilson is in good company. The Los Angeles Times recently reported that several Nobel laureates in economics admit to having trouble managing their own money. One might think that a Stanford MBA—and certainly a Nobel Prize-winning economist—would be well versed in all the different strategies likely to build wealth, but most people who are busy raising families and advancing their careers simply don’t have time to fine-tune their own personal investment plans. Add to that the common sentiment that anyone with an MBA should be able to manage his or her own retirement account, and you get a group of people who are afraid to ask for help. “Not everyone who gets an MBA is an investment guru,” Wilson notes. “But with the MBA comes this psychological feeling that you should be able to do it yourself.”
The rules of building a nest egg have been repeated so often that we all know the do’s and don’ts of retirement planning by heart. Do pay yourself first. Do buy low and sell high. Do make sure you are insured. Don’t put all your eggs in one basket. And while we’re at it, don’t lose tens of thousands of dollars in hard-earned savings by losing track of the account altogether. Practical advice notwithstanding, smart people often do stupid things with their money. So, here, for all of you who should know better already, a reminder of some of the things you should and should not do with your money.
Don't Turn Away Free Money
Failing to sign up for a 401(k) plan in which your
employer matches savings has been equated to setting a match to a wad of
thousand-dollar bills. But the practice continues. “I see it all the time,” says
Eric Tyson, MBA ’89, a financial counselor and author of Personal Finance for
Dummies and other investment advice books. One of Tyson’s clients was a doctor
who earned close to $400,000 a year, took lavish vacations, sent his children to
private schools, and ate at fine restaurants, but had no savings. If this sounds
like you, it’s worth mentioning that the law allows for a so-called “catch-up”
contribution, in which anyone 50 or over may contribute $4,000 a year above and
beyond the official limit, in essence to make up for youthful indiscretions.
Do Read the Fine Print, Especially Related to Fees
When shopping around for the
best mutual funds, it is easy to regard a fee of 1 to 2 percent as a pittance
against all the compounded gains the fund will rack up. But Darrell Duffie, the
School’s James Irvin Miller Professor of Finance, says the difference between a
2 percent fee and a cheap fund that charges as little as 0.01 percent can be
huge in total dollars. Consider a fund with a 1 percent fee. “If you are getting
an 8 percent return, that becomes a 7 percent return after the fee.” But here is
the real catch: Going from 8 percent down to 7 percent actually means losing
some 12.5 percent of your investment funds. Also worth remembering: You pay the
fund fee even in years when the fund value declines. Some expensive funds turn
out a performance that is worth all the extra money, but Duffie says the vast
majority do not.
Don't Try to Beat the Market
It almost never works. Gretchen Frank Carey, MBA
’76, a certified financial planner for Morgan Stanley in Jenkintown, Pa., notes
that this sort of gambling comes in many forms, from trying to hand-pick all the
stocks in one’s portfolio to betting everything on one darling stock. Sure,
certain hot stocks will always look tempting against a plodding index fund in a
slow year, and some will actually deliver year after year. The almost impossible
challenge is to identify those winners ahead of time. Jeff Maggioncalda, MBA
’96, president of Financial Engines Inc., which provides outsourced financial
planning advice for companies and their employers, offers this sobering advice:
“It is very hard to beat the market, yet surprisingly easy to pick investments
that will underperform the market.”
Part of the problem stems from the fact that investing one’s own money is a highly emotional matter, even for the most level-headed number-crunching types. Rather than conduct a thorough analysis of a company’s fundamentals, we tend to be swayed by a stock’s performance last year, glowing press reports, and even what the neighbors are buying. In a recent study into the role emotions play in managing money, Baba Shiv, an associate professor of marketing at Stanford, found that people who had suffered damage to the part of the brain affecting emotions actually made superior investment decisions, provided that none of their cognitive abilities was impaired.
Do Diversify
Professor Duffie argues that for high-income earners,
diversification should go beyond stocks and mutual funds to include bonds, real
estate, and potentially other sources as well. The number one rule of
diversification, which might be dubbed the Enron rule, is to avoid putting all
your money into the stock of your employer. Still, Geofrey Greenleaf, MBA ’68,
founder and principal of Greenleaf Capital Management in Shaker Heights, Ohio,
says he has actually encountered clients with 401(k) accounts heavily weighted
in their employer’s stock who then wanted to increase their exposure further by
investing Individual Retirement Accounts in the same stock. So, how do you
diversify? Duffie advocates inflation bonds and high-quality corporate bonds.
“If you are saving for the long run, like a child’s education or retirement, at
least some component of that should be relatively safe,” he says. And for the
wealthy individuals with multiple millions to invest, diversification can be
carried even further to include things like hedge funds and venture capital
funds.
Don't Forget About Life's Curveballs
Considering that so many high-income
earners are low savers, they can be just as vulnerable as anyone when the
unexpected happens. Few people in any income category really do enough to
protect themselves from a major life disruption like divorce, illness,
disability, job loss, or rising health care costs. “If you get Alzheimer’s and
you have not purchased sufficient health insurance, you can very easily bankrupt
your family,” says Gretchen Carey. Trying to plan for the unexpected is a
challenge, but a good starting point, most financial planners agree, is to
invest generously in life insurance. Geofrey Greenleaf suggests people carry
life insurance worth 20 times their annual income to guarantee a payout that
would equal income. At the very least he recommends covering 60 percent of
income.
Do Try to Be Compensated for Your Work
Sound obvious? Not if you are one of the
many who voluntarily labor without a salary for years while building a business
with your spouse. Such an arrangement can have multiple rewards, from satisfying
work and flexible hours to the potential to make a lot of money in the long
term. But Gretchen Carey cautions that working without getting paid is another
form of gambling with your money and can backfire, especially if the couple
building the business gets divorced. What can you do if the business you are
building has no revenues? At the very least, keep good records and try to come
up with some sort of contract for what stake you have. And if at all possible,
Mary Wilson suggests contributing to some sort of retirement plan all the while.
“When you are unemployed, you still can contribute $5,000 a year to an IRA,” she
says. “It is not a huge amount of money, but it is better than nothing.”
Finally, what may be the most counterintuitive advice of all:
Don't Oversave“Frugal people take joy in seeing money accumulate,” notes Professor Shiv. “It almost becomes a compulsive behavior, and one that can be detrimental.”
Eric Tyson, who advocates a holistic investment approach that addresses personal health and leisure time, says he has found that overworking is often a form of oversaving, and can be a good way to escape life’s other challenges. The remedy? “I try to get people to brainstorm not only about their financial goals but also their personal goals,” he says. “I show them that the amount they’ve already saved can provide this kind of a lifestyle and that they should feel good about what they’ve done already. If they’ve done a good job, they can think about paying off the mortgage, taking a sabbatical, quitting their jobs, or traveling for five years. I try to get them to dream.”
Personal Finance: Investing for Retirement
by Kathleen O'Toole
Magnetic resonance imaging machines are widely used to diagnose physical illnesses. Now they also hunt down abnormalities in theories of the mind. One of the granddaddies of those theories concerns the rational self-interested investor who knows his or her own needs best and will do a better job of investing for retirement than, say, the professionals who do it for California state employees.
Or at least that was what many economists thought before behavioral scientists teamed up with neuroscientists to watch blood flow through the brains of people making investment decisions inside MRI machines.
In separate experiments using functional magnetic resonance imaging—MRI for short, Camelia Kuhnen, a doctoral candidate in economics at the Business School, and Baba Shiv, an associate professor of marketing, found evidence that emotions can interfere with so-called rational investment decision-making.
Kuhnen teamed up with Brian Knutson, an assistant professor of psychology at Stanford, to study students asked to decide between two stocks and a bond during separate games. The volunteers were supposed to figure out which stock was good and which was bad by watching the market while in the MRI machine. The researchers found that the nucleus accumbens, a peanut-sized part of the brain that exhibits excitement when someone expects an immediate reward—such as water when thirsty—lit up with blood flow two seconds before volunteers invested in a stock even though it had a bad history. This suggested they took pleasure from taking risk. In contrast, the anterior insula, a part of the brain linked to anxiety when people are subjected to repulsive stimuli such as pictures of mutilated bodies, lit up just before volunteers decided to invest in the safe but suboptimal-performing bond.
Shiv and colleagues at Carnegie Mellon University and the University of Iowa, studied wagering decisions of people with normal IQs, some of whom had lesions in areas of the brain associated with emotion. Each participant was given $20 to risk $1 at a time on 20 coin tosses. They could decline to participate in all or any rounds and keep their money. Those who participated earned $2.50 if they won but had to give up $1 if they lost.
“From a logical standpoint, the right thing to do was to invest in every round,” Shiv says. “With a 50-50 chance of winning, the expected value of playing each round was $1.25, while the expected value of not playing was just $1.”
Those with brain lesions invested in 84 percent of the rounds, earning an average of $25.70. Normal participants invested in just 58 percent of the rounds, earning an average of $22.80.
Fear seemed to play a large role in risk-avoidance behavior of the normal participants, Shiv says. Over time, the normal participants grew more cautious, declining to play almost as often as agreeing to risk $1 on the coin toss. “And what we found out, through additional analysis, is that normal individuals were reacting emotionally to the outcome of the previous round,” he said. “If they lost money, they got scared and had the tendency to fall back and decline to play further.”
Studies such as these may shed light on the reasons for what financial experts call the “equity premium puzzle,” the large number of individuals who prefer to invest in bonds rather than stocks even though stocks have historically provided a much higher rate of return. According to Shiv, there is widespread evidence that when the stock market starts to decline, people shift their retirement savings—that is, their long-term, not short-term, investments—from stocks to bonds. “Whereas all research suggests that, even after taking into account fluctuations in the market, overall people are better off investing in stocks in the long term,” Shiv says.
“People are not as rational as we would like them to be,” Kuhnen says. “I’m happy we got these results because I believe this is evidence that economists should take [emotion] into consideration when we write [investing] models for individuals.”
The research by Kuhnen and Knutson was published last September in the journal Neuron. The research by Shiv and colleagues appeared in June in Psychological Science.
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