Your brain is not necessarily set up in a way that makes it easy to plan a secure retirement. You have cognitive biases — faulty ways of thinking that are unfortunately hardwired into your brain — that work against you. Behavioral finance and behavioral economics are the study of these phenomena. Understanding behavioral finance and your natural cognitive biases can increase your wealth and happiness.
Becoming aware of these behavioral finance tips can help you do a better job planning and saving for your retirement. Below we also offer specific tricks for overcoming each of the misguided thought processes.
A study in the Journal of Consumer Research found that people who used the words “I don’t” versus “I can’t” — as in, “I don’t eat dessert” instead of “I can’t eat dessert” — were nearly twice as likely to resist the temptation of choosing unhealthy foods.
The researchers believe that using “I don’t” instead of “I can’t” gives people greater “psychological empowerment” by removing the need to make a decision. “I don’t” gives the speaker control whereas “I can’t” denotes a sense of denial, regret and someone else being in control.
Applying Empowered Refusal to Retirement Planning: Think about all of the decisions you make with regards to your finances. A lot of those choices involve denying yourself something in the present so that you can have a more secure future. For example, you want a new bicycle, but you could also be saving and investing that money. To help insure you make the “right” choice:
- Instead of saying: “I can’t spend money on a bike”
- You could say: “I don’t spend money now that I am going to need in the future.”
Use the NewRetirement Retirement Planner to find out how much money you will need for retirement and if you are saving enough now (maybe you really can buy the bike).
As “Nudge: Improving Decisions About Health, Wealth and Happiness” author Cass Sunstein, wrote, “a 5-cent tax on the use of a grocery bag is likely to have a much greater effect than a 5-cent bonus for bringing one’s own bag.”
Research indicates that people are far more stressed by the prospect of losing money than they are by gaining money. In fact, some studies have suggested that losses are twice as powerful, psychologically, as gains.
This can make investment management particularly tricky. You need to be able to take appropriate risk and sustain the potentially temporary losses if you want to ultimately achieve positive rates of return.
Overcoming Loss Aversion: Creating and maintaining an Investment Policy Statement can be one way to help you proactively make a plan for what to do in different economic scenarios, which can help you overcome the negative bias of loss aversion.
So, as explored above, most people are risk averse. But, not everyone.
The key to using behavioral finance to your advantage is to really understand your own motivations. Goals can be framed as gains or as losses. Which of these phrases is more appealing to you?
- Planning retirement insures you won’t run out of money (loss aversion)
- Planning retirement helps you maximize your wealth (gain)
Know What Motivates YOU: When setting goals, try phrasing them in different ways — emphasizing the loss or the gain. See which feels more motivating and focus on that!
In “Happy Money: The Science of Happier Spending,” authors Elizabeth Dunn and Dr. Michael Norton explore how money can make us happy. They report that you can use money to buy happiness by:
- Spending on experiences
- Making a point of treating yourself
- Buying time
- Paying ahead of consumption (the opposite of debt)
- Investing in others
How to Let Money Buy You Retirement Happiness: Retirement is actually a big life trade of money in exchange for time. And, the research indicates that retirement almost always results in happiness (except when it triggers depression due to losing purpose and vitality).
Neurosis is the inability to tolerate ambiguity. – Sigmund Freud
The ambiguity effect reflects a tendency to avoid decisions or options where unknown information makes it hard to predict an outcome.
Examples: When planning your retirement, you need to “know” how long you will live, future inflation rates, investment returns and other factors that are actually unknowable. Not being able to “know” this information can make planning feel ambiguous and impossible and many many people just avoid it altogether.
You might also fall victim to the ambiguity effect with investments — you might opt for bonds where the returns are considered safe rather than stocks which are more volatile but are likely to have higher returns.
Overcome the Ambiguity Effect: One way to use behavioral finance to overcome the ambiguity effect for retirement planning is to assign optimistic and pessimistic assumptions — based on historic norms — for the unknowables. Using best and worst case scenarios makes it a little easier to get your hands around the unknowables. The NewRetirement Retirement Planner lets you do exactly that.
For retirement investments, you might want to tailor your asset allocation strategy to your needs and wants — investing money for needs in conservative vehicles and money for wants more aggressively.
In their book, “Decisive, How to Make Better Choices in Life and Work,” Chip and Dan Heath argue that there are four villains of good decision making:
- Narrow framing (not considering enough options)
- Confirmation bias (only paying attention to what you think you should pay attention to)
- Overweight short term emotions — especially negative emotions like fear
- Over confidence
Plan a Better Retirement with the WRAP Method: Heath and Heath argue that you can combat bad decision making with what they call the WRAP method: 1) Widen your options, 2) Reality test assumptions 3) Attain distance before deciding and 4) Prepare to be wrong.
Change your mind and you can change the world (or at least your future retirement.) – Norman Vincent Peale
Anchoring is the impulse to rely too heavily on one piece of information when making decisions.
Example: When planning for retirement, most people anchor on how much savings they need. However, savings is just one aspect — often not even the most valuable aspect — of your retirement security.
When you start Social Security, whether or not you’ll downsize, figuring out how to turn savings into retirement income and understanding your future spending needs are probably more important than (and certainly impact) how much savings you need.
Overcome Anchoring: Behavioral finance research suggests that educating yourself about all the factors that impact your retirement financial security is a good step to overcoming anchoring.
Birds of a feather flock together.
The bandwagon effect is a behavioral finance observation that you have the inclination to do things because many other people — particularly your friends and family — do them.
Example: Research shows that people who have friends who exercise and eat well are healthier themselves. The same is actually true of retirement planning. People who have friends who are knowledgeable and proactive with their finances are more likely to be financially stable themselves.
Unfortunately, the reverse is also true. And, because the vast majority of people in the United States have an extremely low financial IQ and according to a report from Charles Schwab only a quarter of people have a written retirement plan.
The reality is that the bandwagon effect is probably working against you.
Overcoming the bandwagon effect: Maybe you could start a “retirement club?” A retirement club is kind of like a book club but you discuss retirement topics instead of novels. It can provide a friendly forum for learning about financial topics.
Best of all, if both you and your friends are engaged in retirement planning, then you are using the bandwagon effect to your advantage and stand a better chance of being financially successful.
Beware of false knowledge; It is more dangerous than ignorance. – George Bernard Shaw
According to Wikipedia, choice supportive bias is the “tendency to remember one’s choices as better than they actually were.” Confirmation bias is similar in that we seem to be predisposed to focus on information that confirms our preconceptions.
Example: Choice supportive and confirmation biases seem to be particularly dangerous when it comes to investments. Imagine you get a stock tip. When you research that tip, you are likely to seek information that confirms your tip rather than get a more unbiased perspective.
Overcoming Choice Supportive and Confirmation Biases: There are a few ways to deal with these biases with regards to investments:
- Have an Investment Plan: An investment plan — or asset allocation plan — is a written document that outlines exactly why you are invested in what way and what you will do in a variety of future scenarios. This prevents you from making rash decisions.
- Work with a Professional: Many people simply can not keep their emotions out of their financial decision making. A financial advisor can act as your rational brain and keep your investments on track for the long term.
Risk comes from not knowing what you are doing. — Warren Buffet
The disposition effect is actually specific to investments. It is the tendency to sell an asset that has risen in value and resist selling an asset than has dropped in value. This is not actually the best strategy. It is just a bias.
Example: I am actually guilty of this. I am currently holding $3,000 of some small company that I bought years ago (like 30 years ago) at $7,000. All indications suggest that this company is headed for bankruptcy and won’t last long. However, I don’t really want to sell it. Sure, it’s small potatoes, but I still spend time thinking about it and tracking it and really I should just get rid of it.
On the other hand, I am tempted to take my short term gains on Facebook this week — even though I actually think that Facebook is a good company to hold for the long term.
Overcoming Disposition Effect: As with confirmation bias, avoiding emotional and irrational decision making is extremely helpful:
A bird in the hand is worth two in the bush.
The endowment effect is the phenomenon that people “demand much more to give up an object than they would be willing to pay to acquire it.” People think that things they already own — especially things with emotional meaning — are more valuable and tend to want to hang on to them.
Example: Homes are usually a person’s most valuable asset. However, the majority of retirees are somewhat wary of downsizing or tapping into that home equity — even if they might need or want the money.
Sometimes the reluctance is due to wanting to retain the asset for heirs, other times they want to stay where they have always lived (even if it is not suitable for their current needs). Whatever the reason, homes are an emotionally charged asset so the the endowment effect is probably an extremely powerful force.
Overcoming the Endowment Effect: Being aware that your brain has this tendency to want to keep what it already has can probably help you behave more rationally. Making lists of the pros and cons of retaining an object or asset can also help you make a more informed and mindful decision.
Ask yourself questions: If you didn’t already own this, how much would you pay for it? How much effort would you put into acquiring it?
Continuing with the housing example, making a list of everything you could gain from selling your home — a better lifestyle, lower cost basis, earlier retirement or being closer to family — might help you get over the endowment effect.
Try out different what if strategies for tapping home equity when you use the NewRetirement Planner.
Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair. – Sam Ewing
Money does not have intrinsic value. The value of money resides in how much it can purchase — which changes over time.
The money illusion is the tendency people have to think of the nominal value (the numerical amount) rather than the purchasing power of that money.
Buying power — how much you can buy — is more important than how much money you have. And, the purchasing power of your money in retirement is more important than the balance of your accounts.
Example: How much is $1 worth? Well, ten years ago, a dollar could buy a candy bar. And, it might seem like $1 would still buy a candy bar, but the reality is that the average price of a candy bar is more than a $1.50. Nevermind the fact that it cost 5 cents back when most of us were kids.
The money illusion can be really confusing to people, but it is critical to understand this concept — especially with regards to inflation and inflation’s potential impact on your retirement finances.
Think about your investments. If you are getting a 6% return on investments, but inflation is rising at 3.5%, then the real value of your ROI is only 2.5%.
Overcoming the Money Illusion: When planning retirement, it is critical that you factor inflation into your calculations.
A good retirement planning calculator will project inflation rates and factor that into your results.
- The NewRetirement Planner actually allows you to set your own optimistic and pessimistic assumptions for retirement and try different what if scenarios with these numbers to help make the money illusion concept very real. Immediately see how your finances shift every time you change inflation rates or any other number in your plan.
Present bias is the tendency we have to value the moments that are closer to the present than those farther in the future.
It is not in the stars to hold our destiny but in ourselves. — William Shakespeare
Example: It is a well documented phenomenon that you are more likely to spend money this month on something that gives you pleasure now rather than save that money for your future self. Present bias is one of the BIG reasons that retirement savings is so difficult for so many people.
Overcome Present Bias: One way to overcome this bias is to imagine or even view a picture of what you might look like as an old person — even a really old person. Research indicates that if you can truly visualize yourself in the future, then you are more likely to save money, eat better, exercise and generally plan to take care of your future self.
In his book, “Upstream: The Quest to Solve Problems Before They Happen,” author Dan Heath tells a story commonly attributed to Irving Zola: “You and a friend are having a picnic by the side of a river. Suddenly you hear a shout from the direction of the water — a child is drowning. Without thinking, you both dive in, grab the child and swim to shore. Before you can recover, you hear another child cry for help. You jump back in the river to rescue her as well. Then another struggling child drifts into sight… and another… and another… The two of you can barely keep up. Suddenly, you see your friend wading out of the water, seeming to leave you alone. “Where are you going?” you demand. Your friend answers, “I’m going upstream to tackle the guy who’s throwing all these kids in the water.”
The point of the story is that you can’t always act and react to the present, at some point, you need to get above the fray or into the future and solve the underlying causes of problems, not just the issues happening to you at any given moment.
Move Upstream to Have a Secure Retirement: You can’t have a secure retirement if you are always having to figure out how to pay for everything you need today. You need to get upstream of retirement by planning, saving, budgeting and investmenting.
The status quo bias is the impulse to keep things the same. It is more comfortable to keep going as you always have than to make any kind of big change. In fact, sometimes abandoning the status quo takes the proverbial leap of faith.
Life is traveling to the edge of knowledge, then a leap taken. – D.H. Lawrence
Example: While we are all pretty excited about retirement, it can be awfully hard to take the leap and actually stop working. Part of the difficulty can be attributed to our desire to just keep the status quo.
Overcome the Status Quo: Here are a few tips from Coaching Positive Performance about overcoming the status quo bias:
- Review past big changes or challenges — this will remind you that you are capable of transformation.
- Break it up into smaller actions — Maybe you shouldn’t retire all at once, how about taking a long sabbatical first or going part time for awhile.
- Identify obstacles — You need a solid plan if you are going to retire. Documenting a detailed retirement plan can help you identify stumbling blocks and how you will overcome them. Or, explore some of the likely things that might go wrong in your future — and plan for them.
James Clear writes in his book, “Atomic Habits: An Easy & Proven Way to Build Good Habits & Break Bad Ones” about how, when you want to make a change, it is more important to adopt very small changes rather than trying to fix everything all at once. He argues that tiny changes and marginal gains allow us to get rid of bad behavior and develop good habits.
So, you don’t need to become a millionaire this year, you just need to start saving — even saving small amounts.
Clear argues that goals are not as important and systems. He says that “goals show you the right direction, but systems are better for making progress.” A system is something you can enact day after day. A goal is something that takes a long time to achieve and the boost of achievement is just a one time event.
Atomic Habits for a Better Retirement: Instead of focusing on how much you need to save to achieve a secure retirement, break down the goal into daily actions — how much can you save each day and what mechanisms do you have for tracking and rewarding or acknowledging your daily achievements?
And, for planning, instead of meeting with your financial advisor once a year, create your own retirement plan and check in on it monthly or quarterly, making small adjustments for more wealth in your future!