Consider the following choices:
1) You are offered a snack to eat now – would you prefer a chocolate bar or an orange?
2) You are offered a snack now to eat next week – would you prefer a chocolate bar or an orange?
People predominantly choose the tasty but unhealthy snack for immediate consumption, but pick the healthy snack for the future. However, once that future date arrives, if given the option to switch, they again go for the high-sugar high-fat chocolate bar.
This example highlights one of the main behavioral challenges in saving for retirement: as humans, not only do we tend to overweight our experiences today at the expense of those in our future, veering towards instant gratification, but we also change our preferences over time. In effect, we make choices today that our future selves would prefer not to be making, whether it’s to eat healthier or quit smoking. This is known as the present bias. In today’s post, we’ll take a look at this phenomenon – and several others – that investors often face when saving and investing for retirement.
What are some common saving and investing behavioral derailers?
In addition to present bias, behavioral mistakes in saving and investing for retirement include:
- A lack of discipline to take the actions we know would be right for the longer term.
- Procrastination and a preference for the current state of affairs, also known as the status quo bias. This can arise for a variety of rational and behavioral reasons including lack of motivation, greater sensitivity to losses than gains (loss aversion), and the fear of potentially making a wrong decision.
- Rules of thumb such as anchoring, an over-reliance on the first piece of information offered, and naïve diversification rules.
- Overconfidence and other biases that have been found to plague individual investors’ portfolios in general.
What are the financial implications of behavioral biases?
The above behavioral biases can meaningfully impact the ability to meet one’s financial retirement goals
Procrastination and the status quo bias can delay or prevent people from signing up for retirement plans, even when tax advantageous and with added incentives such as company matching contributions. In an extreme example, a study found that in a sample of 25 defined benefit plans in the United Kingdom that were fully paid for by the employer, only about half of the eligible employees signed up. Further, the greater the number of funds offered by the plan, the lower the participation rate, presumably thanks to the added complexity of the decision problem.
Anchoring can cause retirement plan participants to stick to the generally low default contribution rates, perhaps believing them to be an implicit plan recommendation. Other naïve rules of thumb, such as contributing just enough to maximize company matching contributions or simply picking the maximum allowed rate, are also blind to an individual’s true funding needs. As for asset allocation, people sometimes use diversification strategies such as dividing their savings equally across funds, or some other arithmetically simple rule. If plan participants are offered a large enough number of funds to cause a choice overload, they may simply give up and just go with the safest fund in the menu.
Overconfidence and other types of biases that plague individual investors’ portfolios in general, which can lead to a heavy concentration in the employer’s stock and under-diversification, and poor stock market timing, have also been discovered in retirement portfolios.
The obvious risk of these poor saving and investing behaviors is insufficient income at retirement. Research shows that the average working US household has virtually no retirement savings, and even when considering not just retirement assets, but total net worth, around 65% of households fall short of conservative retirement savings targets for their age and income.
How do you mitigate the impact of biases?
While financial education by itself hasn’t been found to be very successful in tackling behavioral biases, there are three steps investors can take to improve their retirement savings behavior:
- Tackle procrastination. Address the inherent complexity in saving for retirement by breaking tasks into less intimidating components, getting financial advice in the process if needed. Set explicit rewards for completing individual tasks.
- Frame the problem differently. Focus in as much detail as possible on the happier retirement that can result from saving and investing today, rather than the immediate monetary loss from saving. The more vivid the picture of a happy retirement, the more powerful this method is likely to be in changing behaviors.
- Use software tools. Creating realistic depictions of aged versions of yourself can help bridge the gap between how much you care about yourself today vs. in the future.
This is where, as an investor, knowing yourself is especially valuable. You can read more about that here.