gains; and as the magnitude of losses increases, aversion can
increase, especially as losses become large enough to force a
change in lifestyle (Kahneman and Tversky 1979). For retirees
specifically, it has been shown that losses may have ten times the
emotional impact as gains (Johnson 2010), and this hypersensitivity
to losses may make retirees more prone to panic and abandoning
their strategies, especially in light of losses such as those in 2008.
Regarding cash flow, loss aversion “favors minimal changes to the
status quo” (Kahneman 2011a) and a pay cut is likely to have more
emotional impact than either a pay raise or failing to receive a raise.
Time-discounting is the tendency for people to overvalue the present and discount the future (Lowenstein and Prelec 1993), and it’s
why telling people to focus long-term goes against human nature.
One reason the financial services industry has struggled to develop
wealth-distribution approaches that resonate with investors is that
most industry research is focused long-term, but investors are
more concerned with the short-term.
Per prospect theory, people view risk on the basis of gains or losses
from a reference point that most often is a current asset level but may
be an expected level, and given enough time the reference point can
change (Kahneman and Tversky 1979). Saving for retirement is
about managing to achieve a goal by growing a small pool of money
into a larger pool. Retirement income is about keeping a large pool
of money from becoming too small. This makes the amount you
have at retirement an especially important reference point, and retirees are focused on maintaining value rather than attaining it.
The second cornerstone of prospect theory is that people do not
value probabilities in a linear fashion. In general, people overvalue
low probabilities and undervalue medium to high probabilities
(Kahneman and Tversky 1979); they overvalue rarer events. In
other words, if a target event is very likely, its alternative becomes
the focus, and the emotional arousal is insensitive to the exact level
of probability (Kahneman 2011a).
Along with overestimating probabilities, people are prone to overweigh outcomes. This is partly due to an “availability heuristic,”
which causes people to judge an event as more likely the easier it is
to imagine or recall. Simply discussing a low-probability hazard
“may increase its memorability and imaginability and hence its
perceived riskiness, regardless of what the evidence indicates”
(Slovic et al. 1982). Factors such as vividness, immediacy of consequences, or past experience—especially if they are recent—can
make an event easier to recall or imagine.
The more vivid the risk, the easier it is to recall, because the human
brain tends to give priority to bad news and responds quickly to
even symbolic threats (Kahneman 2011a). Because losses have
more emotional impact than gains, catastrophic scenarios can be
5 This bias to give greater weight to negative out-
comes, especially worst-case outcomes, is in line with the concepts
of negative potency (Rozin and Royzman 2001) and “bad is stron-
ger than good” (Baumeister et al. 2001). It explains why investors
always want to know the worst that can happen.
The immediacy of consequences affects attitudes toward risk (Slovic
et al. 1982). A catastrophic loss such as the one shown in table 4 is
likely to have an immediate impact on cash flow and standard of
living—and it is likely to substantially increase loss aversion.
Recent events also are easier to recall and the availability heuristic
highlights the importance of experience as a determinant of perceived risk. For example, Slovic et al. (1982) cite researchers who
have blamed the difficulty of improving flood control on the
“inability of individuals to conceptualize floods that have never
occurred.” This explains why people tend to assume that what has
happened recently, such as stock prices going up (or down), will
continue. This is also why retirees who experience some erosion of
principal during the first year of retirement will project that rate of
erosion to estimate how long their savings might last. Because of
negativity bias, investors want to know the worst that can happen,
but their comfort level is bounded by the worst that has happened,
especially recently. For this reason, solution providers should articulate how their strategies would have performed in a recent historical worst-case environment.
In a 2010 survey by IBM of 1,500 chief executive officers (CEOs)
from sixty countries and thirty-three industries worldwide
( 18 percent from financial services), CEOs reported that they felt
retIreeS face new
chaLLengeS that caLL
for new SoLutIonS
so is a distraction.