A famous DALBAR study concluded that the average investor consistently underperforms the returns of broader market indices.
When you think about your retirement plan, you may believe your success only has to do with a simple mathematical answer. But when it comes to any financial planning topic, there is often the math answer and the emotional answer. Neither is ever “wrong.”
Financial planning is meant to be personal and unique to the individuals’ goals, wishes, and dreams. Because of that, there are many nuances to the “art” of financial planning. As humans and emotional creatures, our natural tendencies, biases, and preferences frequently get in the way of making rational decisions when it comes to money, investing, and planning for the future.
In this article, we make a case for embracing behavioral economics to illuminate those tendencies and help you make better, more fulfilling choices down the road.
What Is Behavioral Economics?
While a relatively new area of study, behavioral economics has made significant and telling contributions to society. Behavioral economics studies the psychology of decision-making processes in individuals and institutions.
It seeks to answer “why”:
- Why was a decision made?
- What were the underlying influences?
- How was the decision made, and what biases exist?
When it comes to retirement, you can start to see how understanding behavioral economics may be helpful as you plan for something so far in the future.
While there are many important concepts to grasp within behavioral economics, understanding the ideas of behavioral biases and hyperbolic discounting are critical if you want to save your retirement plan from irrational decisions.
Breaking Down Bias
Biases, like consequences, are not always a bad thing. It is prudent to understand your inherent biases so that you can make more informed choices.
While more may be included in this list, the most common biases that exist in retirement planning are as follows:
- Default bias
- Status-quo bias
- Rule-of-thumb bias
The default bias is humans will more often accept what is given and stick with what they have. This is why employers should enroll employees in retirement plans and increase contributions automatically.
Status-quo bias has to do with the cognitive preference of keeping things as they are or maintaining the current state of affairs. This can be a big issue for investors saving for retirement but never leave their “financial advisor” charging a 2% AUM fee and has not spoken to them in over two years.
Rule-of-thumb bias is simply using mental shortcuts to solve problems quickly. These are not always bad, but decisions need to be optimized at the individual level and never cookie-cutter when it comes to financial planning.
Hyperbolic Discounting & Retirement
Many people often have a difficult time prioritizing their future needs over their current ones. We live in a society that glamorizes instant gratification.
The fancy way to describe this phenomenon is hyperbolic discounting, or a person’s tendency to choose smaller, immediate rewards over larger, future ones.
Why is this bias so powerful? It is all about value and the many ways it changes over time. For humans, we value the present more than we value the future.
When retirement remains a distant, future event, it is much simpler to assign it a lower value, when in reality, its value far surpasses present circumstances. This is problematic as it can skew your decisions today, putting your future self in a challenging position once it is time to retire.
Where Dreams Become Reality
So how do you overcome your innate behavioral biases and irrational behaviors?
How can you combat the effects of your short-term tunnel vision?
Envisioning your future self is proven to be an effective tool. This is known as conceptual priming and can help your present self-better align, empathize, and connect with your future self. This ultimately adds meaning and value to your future.
Start dreaming about your ideal retirement to give you more motivation to save the way you should live the life you want.
This concept is so impactful companies are working on using virtual reality to plan your retirement, as highlighted in this NY Times article. If you saw a virtual version of your future self in retirement, you can quickly see how that may impact your present savings decisions.
Schedule Time To Talk
Financial planning, and more specifically, retirement planning is not a one-size-fits-all task. There is nuance, emotion, and many complex decisions that need to be made over a lifetime. Besides, we are often blind to our own behavioral and cognitive biases and need someone else to keep us from hurting our future selves.