Did you know that Americans have a preference for certain numbers, and in particular the number zero? This may seem like a harmless fact, but this odd quirk of human behavior could be very costly.
The problem, according to recent research: Some people with a bias toward zero are choosing the wrong target date funds in their retirement accounts and are exposed to the wrong level of risk because of it. This zero bias has also caused others to make a pick that exposes them to more risk and thus earn better returns (but that won't always work out).
Here's why this is such a problem, along with how to fix it.
How the zero bias could lower your retirement nest egg
Target date funds are a popular 401(k) investment because they're simple. You specify the date when you want to retire, and your money is invested in a mix of assets that expose you to the right level of risk given your target date (hence the name).
Basically, what these funds do is invest an appropriate percentage of your portfolio in stocks given your timeline for retiring; then, they shift your investment balance so you get less equity exposure as you age and get closer to the day you'll need to begin making withdrawals.
But getting the right asset allocation hinges upon picking the date you realistically expect to leave the workforce. And recent research from Iowa State University revealed that many people aren't doing that. Instead, they tend to gravitate toward funds ending in zero instead of five. And for those born in years ending in eight or nine, this often leads to the selection of a target-date fund that matures before they actually want to retire. The results: They are underinvested in equities, and their returns are lower because of it.
Take, for example, someone born in 1989 who wants to retire at 66. The correct fund would be a 2055 target date fund. But a preference for zeroes might lead the investor to opt for a 2050 target date fund instead. It may seem hard to believe, but the study showed that as many as 34% of people born in years ending in eight or nine made this type of decision, choosing a fund that had them retiring ahead of schedule. Sadly, the research showed that all of them ended up worse off financially. It also found that men, higher-income earners, and older Americans were more likely to demonstrate this zero bias, while those who had participated in a financial planning program were less likely to do so.
By contrast, those who were born in years ending in zero through two tend to do the opposite due to their preference for zero, with as many as 29% of people born in those years opting for target date funds with a later retirement date than they had planned. The research showed these workers generally end up better off than they would have if they'd chosen the correct fund. Although those who are risk-averse may not be happy about the fact they've taken on outsize risk by overinvesting in stocks.
How can you fix it?
Fortunately, there's an easy fix to the zero bias: Don't give in to it. Instead, if you plan to invest in a target date fund, be sure to pick one as accurately as possible so you maintain an appropriate asset allocation. Or if you want to be a little more aggressive and accept a bit more risk with the potential for greater rewards, you could do what those born in years zero through two often did and pick a target date fund that shows you retiring a bit later than planned.
Alternatively, you could opt out of target date funds altogether, pick other investment types, and simply manually rebalance your portfolio as you get older. That takes a little more effort, but it also requires you to make a more-conscious assessment of your level of risk and decide if you want to lean a little more aggressive to improve your potential returns. If you go this route, though, don't get complacent or you could really put your retirement in jeopardy.