Written by: Northwestern Mutual Insights & Ideas Team
Financial planning involves a series of seemingly endless decisions. Should you participate in an employer-sponsored retirement savings plan? Where should you put money for the best investment return? Should you save less for your child’s education to save more for your retirement?
Whenever you’re confronted with having to make these decisions, you become a test case for behavioral economics, a discipline that explores irrational thinking and economic decision making in a person’s daily life.
Even if you are a rational thinker, you may exhibit behavior that is predictably irrational when it comes to money. If you can recognize irrational behavior, you can take steps to avoid it and make better financial decisions. Do you show signs of any of the following?
Anchoring is defined as the heavy reliance on one piece of information (anchoring to it) when making a decision. The information in question may not be accurate or even logical. It might simply be a reference for comparison.
A classic example involves clothes shopping. Who hasn’t spotted clothing with an enormous price markdown? In this scenario, the original price is provided as an anchor, something for comparison. The new price becomes a “steal” too good to resist. But is it really?
While retailers provide anchors, investors often create them in their own minds. A stock, mutual fund, vacant land or rental apartment building that has dropped in price may look attractive relative to its previous high price. In reality, the lower price may still be too high.
Avoid being drawn into anchoring by not limiting yourself to a single point of view. Seek information from a variety of sources, and view situations from different perspectives.
Why is it that a gain in retirement accounts at the end of the year doesn’t feel as good as an equivalent loss feels painful? Loss hurts approximately twice as much, according to research in the paper “ Prospect Theory: An analysis of decision under risk. ”
Loss aversion explains, in part, why retirement savings-account contributions are usually automatically deducted from a paycheck. If you had to actively deduct retirement savings, health insurance and taxes after getting paid, behavioral economists say your sense of loss would increase. You’d likely still pull out money to pay Uncle Sam, but you’d also be less inclined to consistently contribute the same amount or more to your savings plan.
Loss aversion applies to potential investment losses as well. Fear of loss can cause you to make investment decisions that are too safe, resulting in low returns that may just barely keep up with rising costs.
If you’re someone who likes to invest in the stock market, you probably understand the concept of loss aversion as it applies to a poorly performing stock. It’s not uncommon for an investor to keep a poor performer when evidence suggests it should be sold. An investor hoping to avoid the pain of lost money by keeping a stock that should be sold may be exhibiting loss aversion.
If you find yourself in any of these situations, stop and think them through. Simply being aware of the irrational extent to which you might go to avoid real or perceived loss may help you make better financial decisions.
Writer Oscar Wilde is credited with having once said, “I never put off till tomorrow what I can do the day after.” This sentiment might have worked for him, but it’s a terrible way to approach financial planning.
Why do people so often procrastinate when it comes to financial planning? Behavioral economists say it has to do with temporal discounting , valuing immediate gains over future gains. This helps to explain why you might firmly believe eating right is good for long-term health, but a chocolate sundae available right now quiets your inner rational voice.
On a financial level, temporal discounting is a big reason not everyone who can participate in an employer-sponsored retirement savings plan actually does so. It seems logical that any employee offered an employer-matching contribution typical of these savings plans, essentially free money, would take it. Yet, according to the American Benefits Council, approximately 13 percent of eligible participants do not enroll when the plan is offered.
Some employers, in an effort to increase plan participation rates, have positioned them as opt-out plans instead of opt-in. Employees have to actively decide not to participate. Framing participation this way tends to increase employee participation rates.
If procrastination is like bedrock to your way of thinking, can you overcome it? Yes. You could try pre-committing to a deadline for the activity in question and self-imposing a costly penalty for missing it. Studies have demonstrated that this tactic works.
Become Your Own Ally
When it comes to financial planning, you can learn to avoid irrational behaviors. Additionally, a financial professional can assist by helping you to identify your goals and implementing a financial plan to help you reach them. A financial plan can help you see how your decisions impact your finances. Taking these steps can help you avoid succumbing to innate irrationality.