Traditional economic theory is based on the premise that we are rational and make decisions based on logic and without emotion. But in the real world, while we may think we are behaving rationally, we have unconscious behavioral tendencies with the potential to throw us off course.
This can go a long way in explaining why so many of us struggle when it comes to saving for our retirement – whether it’s making investment decisions or getting started with saving in the first place.
Behavioral finance is a field which looks at the psychological factors that can influence us when making financial decisions, none more so than when it comes to saving for retirement.
One of the biggest factors is “present bias”, which sees us place a greater priority on what we want or need today than on what we’ll need in the future. So while planning this summer’s vacations seems reasonable, it can cause us to divert money budgeted for retirement.
“Status quo bias” keeps us from changing our normal patterns of behavior, even when we know it’s the right thing to do (such as starting to save for retirement). Over-optimism is also a common trait where we believe ourselves to be the “lucky ones” – and that misfortune will only happen to others. From there it’s but a small step to think that a reluctance to plan for retirement won’t have any grave consequences.
These are just some examples of how our unconscious mind can influence our actions, often to our detriment.
Taking the pain out of choice
Experts are using behavioral theory to encourage successful retirement planning. For instance, employers are battling present bias by coming up with ways to convince us to enroll in retirement savings schemes.
The most common reasons for not having retirement plans in place are procrastination, and spending our money elsewhere. Left to our own devices, we tend to agonize over the investment choices in our retirement savings plans. However, researchers have found that if an employer removes the need for us to opt in and instead auto-enrols us into a pension scheme and allocates a respectable percentage of our after-tax income to it, we’re pretty happy with the outcome. If not, we would have to decide to opt out – but studies show that we rarely do.
This is known as ‘nudge theory’, a concept developed by Richard Thaler, an eminent behavioral scientist at the University of Chicago and a winner of the Nobel prize in economics, who compared saving for retirement as akin to people “being asked to build their own cars.
Working with the science
While retirement-plan sponsors ponder ways to incorporate research findings in the products and services they offer, individuals can make good use of that knowledge themselves:
– You can create your own “nudges”. For example, rather than trying to remember to make contributions to your retirement savings each month, try setting up a standing order to make automatic contributions – your own auto-enrolment of sorts. There are also apps and banks that will round your purchases to the nearest dollar and put the change directly into your savings account. Budgeting apps can also help you keep track of your spending and automatically alert you when you’ve overspent.
– Peer pressure can be an effective tool in encouraging positive behaviors. That’s why many weight-loss programs use group weigh-ins to motivate people to stay focused on their goals. So if you can get your company to share (anonymously) aggregated peer data in terms of savings levels and performance returns, that is likely to galvanize you to save more and give more thought to your investments.
– If you have already started investing for your retirement, be careful of something known as the “endowment effect,” which makes us overvalue what we already own. This can jeopardize our success in managing our retirement portfolio if we end up sticking with something unprofitable. So make sure you invest in a range of different investments (known as diversification), which can help reduce the impact of any single bad investment – remember, don’t put all your eggs in one basket!
The best news is that – informed by the work of behavioral economists – we can spot how aspects of our psychology might derail our retirement plans, and use that knowledge to get on the right track to savings success.
This article is written by Schroder Investment Management.