Suppose just as you were getting ready to retire someone knocked on your door and informed you that you just won $10M. Would this news affect how you would manage your money? The answer to this question would probably be one of five different responses:
Answer Type #1: "I would increase my lifestyle spending"
If you are like most lottery winners, you will probably respond in this way - realizing some immediate enjoyment out of your newfound wealth.
Answer Type #2: "I would decrease the risk profile of my investments"
Before realizing this windfall, you may have assumed investment risk in order to meet long-term retirement needs. This additional savings will now allow you to meet these needs with more certainty, so you may prefer to "cash in your chips" and get out of your risk position while you are still ahead. This response would also include a decision to use some of the proceeds to purchase insurance to lower your future risk.
Answer Type #3: "I would increase the risk profile of my investments"
This is the "house money" response - because the money was neither anticipated nor depended upon, there will be little pain felt if you were to lose it, so you "double down" on your risky investments. Another reason for responding in this way is because of an increased appetite for risk; because you have more financial resources you have a greater ability to weather significant investment losses, so you decide to parlay your winnings. This response would also include a decision to drop or reduce insurance coverage that you have had, essentially using the winnings to "self insure".
Answer Type #4: "Some combination of the above responses"
More likely than not, you probably would use some of the winnings to increase your lifestyle, and also adjust your investment profile in some way.
Answer Type #5: "It wouldn't affect my financial plans at all"
This may be the response from the ultra-affluent, where $10M is not enough to influence behavior, or perhaps from someone who was otherwise content and would just prefer to squirrel away the additional savings.
How you respond to this question defines your financial behavior, or how changes in your wealth influence how you invest your money, spend it, or insure it. Your behavior is a result of a complex interaction of various factors, including the extent to which you wish to avoid risk (or, your "risk aversion") and the satisfaction, or "utility", that you realize from increasing your lifestyle or consumption.
There are two other aspects that you must also consider when eliciting your financial behavior:
1. How Losses Affect Your Financial Decisions
While the example above focused on a favorable situation, it is also important to understand how you would respond in times of economic adversity. Would you tighten your belt and reduce your spending? Would you become more conservative with your investments, fearing further losses? Or, would you increase your investment risk, hoping to benefit from higher returns to grow your way out of your predicament?
For most individuals, the pain associated with a "loss" is greater than the satisfaction you get from a "gain" of an equal dollar amount, and the bigger the loss the more this is true.
2. At What Threshold Do Your Answers Change?
If you won one dollar, your behavior would probably be different than if you won $10M. Everyone has different thresholds where their behaviors would change. For example, a gain or loss may not have any impact on your behavior until some kind of minimal threshold is met. Typically, these thresholds are a byproduct of how much money you have and your level of risk aversion. In addition, the threshold is probably not going to be symmetric (that is, the threshold of a "gain" affecting your behavior will be different, and probably higher, than the threshold of a "loss). Your behavior may also be different for a loss vs. a gain. Generally, people become more liberal and risk-tolerant when they experience a gain above a certain "upper" threshold and become more conservative when the experience a loss below a "lower" threshold. This phenomenon was documented by Harry Markowitz in his landmark paper "The Utility of Wealth".
The main point is to think through different gain and loss scenarios, and the point at which you will likely change your spending and/or investing behavior.
As Unique as a Thumbprint
Your financial behavior is unique. It will be influenced by how much money you have, the income sources that you have in place for retirement, your confidence in those income sources, your historical experiences, and your tolerance for risk. Even two people who have share the same wealth and experiences can exhibit different behaviors (for example, spouses with different risk tolerances).
There is no "right" or "wrong" way to behave in a given situation, because the emotional effects are quite real and should not be ignored. So, what about the person who moves their investments into cash when the market crashed - was this the right thing to do? Well, I would argue that given this behavioral preference this person should never have been invested in stocks to begin with! Unfortunately, the emotional pain of further losses is just so great that moving your money out of stocks is a very sensible response, although the "rational" action would be to sit tight and stay the course.
Hopefully, this example makes it clear why it is important to assess our financial behavior before implementing a financial plan, as opposed to finding out too late that your strategy was not a good fit.
Why It Matters in a Retirement Income Plan
Understanding your financial behavior is a critically important factor to consider when crafting a retirement income plan. For example, if you are inclined to move your investment portfolio toward more conservative investments if you realized losses, you should consider (A) staying away from risky investments (B) planning on spending less, and/or (C) buying insurance that provides a safety net.
Buying insurance can have a positive influence on your behavior, particularly if you are highly risk-averse. With a "safety net" firmly in place, you may be more inclined to take greater investment risk which may, in turn, have a positive effect on your portfolio over a long-term horizon.
If you are sharing your retirement with someone else, it will be helpful for both of you to discuss how you prefer to handle different scenarios, both good and bad. This joint discussion can help identify conflicts that you may want to avoid, which may affect the design of your retirement income strategy, and/or allow you to understand how strongly each of you feel about protection, opportunities to grow wealth, and your exposure to risk - all of which can help foster a more harmonious retirement.
A word of caution - beware of retirement income plans that have built upon the assumption that you stand still and do not respond to different economic scenarios. This is clearly not reflective of what would happen and, therefore, renders the results of such analyses utterly useless.
As you can see, identifying your financial behavior is an important part of creating a thoughtful retirement income plan, so it is imperative that your behavior is understood TODAY...not something to be discovered in the future.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.