When it comes to money, everyone makes bad decisions. And it’s not because contributing to a 401(k) requires a PhD in physics. It’s often because our brains are hard-wired to prioritize short-term gains over long-term benefits.
“Traditional economic theory suggests that investors are rational decision-makers, carefully weighing all available information to make choices that result in the best possible outcome,” a Legg Mason report on behavioral finance explains.
Years of behavioral economic research have shown how untrue that is. Here are a few ways your brain trips you up and tips to help you avoid falling into these cognitive traps.
One of the most significant psychological factors impeding people from achieving their savings and retirement goals is inertia. There are various ways inertia — sometimes called the status quo bias — manifests itself. It can be as simple as keeping the same cable plan that costs $120 a month even though a competitor cable provider has a similar plan for $100.
Saving in a 401(k) plan is another big one: Studies have found that despite being given the opportunity to enroll in a 401(k), with an employer match, employees tend to be passive. Procrastination sets in; it’s much easier to just imagine doing the right thing in the future. Many more employees say they plan to take action and enroll than actually do.
That’s why more companies have found success with automatic enrollment: In one company that adopted automatic enrollment (when employees first become eligible for the savings plan, they’re automatically enrolled unless they opt out), 401(k) participation rates for new workers increased from 49% to 86%. (But be aware there’s also a downside to automatic enrollment. A 2013 report from the Center for Retirement Research at Boston College showed that if you start workers at a low default contribution, they rarely take action to increase their rates over time and may still come up short as they near retirement.)
So how can you overcome your tendency to do nothing? Automate as many aspects of your finances as you can. Set up automatic bill pay for recurring bills. Save in a 401(k) plan if you have one and see if your plan offers an auto-increase feature. Another way to get motivated is to imagine life 20 or 30 years from now. A study by two researchers found that people shown vivid images of their older selves — where they looked 68 or 70 — were more likely to make decisions that favored long-term rewards.
We hate losing.
Loss aversion is the tendency to avoid accepting the reality of losing money. Put simply, you just can’t bear to admit you made a mistake – and it’s something that should be familiar to investors who find themselves holding onto a loser stock.
“Psychologically speaking, the pain of losing $100 is approximately twice as great as the pleasure of winning the same amount,” Shlomo Benartzi, a behavioral economist at UCLA Anderson School of Management, wrote in a report for Allianz Global Investors (Benartzi is also chief behavioral economist at Allianz). We’ll spare you the evolutionary reasons for humans’ tendency for loss aversion, but suffice it to say it’s an expensive trait.
Selling a losing stock is painful, so many investors just avoid a short-term loss, often at the expense of longer-term goals. it. And at the same time people often sell winning stocks too soon because it realizes a gain — and who doesn’t like that? The mistake here is looking at your investments in separate pieces rather than as a whole.
Is it possible to get over this bias? Richard Thaler, behavioral economist at the University of Chicago Booth School of Business and author of the book “Nudge,” has suggested that retirement savers — especially those who have a long time horizon — should invest in a globally diversified portfolio of stocks, “and then scrupulously avoid reading financial news articles or, even worse, watching financial news networks. Paying attention day-to-day is damaging to one’s financial and emotional well-being.”
We can’t walk away.
It’s happened to all of us: You spend money on something and for some reason you don’t end up using it. But you don’t want to give up on it because you’ve invested all that money. It could be sitting through a movie you hate or continuing to make payments on a car you can no longer afford. It even could be driving 20 miles out of your way to a store to look for a particular pair of jeans and buying something anyway even though the jeans aren’t there — because you invested time and gas money to get to that particular store.
In economic terms, a sunk cost is an expense that can’t be recovered. This notion of needing “to get our money’s worth” comes into play in a lot of financial decisions. Companies do it, too: They continue with a project if they’ve invested a lot of money, effort and time in it — even when continuing is not the smartest thing to do. The best way to deal with a sunk cost is to accept it and move on.
So if you catch yourself in a sunk cost scenario, remind yourself that just because you’ve already spent a certain amount of money on a thing doesn’t mean you should continue to do so.
Have you fallen into these traps or figured out ways to overcome them? Tell us using the hashtag #WAYSTOSAVE on Twitter, Facebook, or email them to us and we’ll feature some of your best tips at the end of the month.