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.
We procrastinate.
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.
Culled from yahoo finance
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