I’ve often said that achieving personal financial success is 80 per cent psychology and 20 per cent math. Every financial decision you make involves both emotion and logic. It’s been said that when emotion and logic come into conflict, emotion usually wins. One example of this is why we tend to chase performance in investing. It’s psychology that tends to cause us to think that past winners will be future winners despite the reality that investing is not that easy.
Behavioral finance is a field of study that seeks to understand the psychological and emotional influence of why smart people make irrational financial decisions. Here's some other articles I have written on the topic:
- Investment Decisions Using Behavioral Finance
- More Behaviors of investing
- Is investing emotional or logical?
More recently, I have watched some great videos on the topic of psychology and saving money.
How to increase savings rates?
In a TED talks video, Economist Shlomo Benartzi (a leading authority on behavioral finance at UCLA Anderson), talks about how to increase savings rates using behavioral finance
- Automatic enrollment – he talks about the organ donation example where people tend to do nothing whether you give them the option to opt in or opt out. As a result, to increase savings rates, its better to automatically enroll people with the ability to opt out than to give people to opt into savings.
- Framing – If you are given a raise or a bonus, saving part of that raise or bonus can be framed negatively because you now have to give up spending. The alternative is to position the raise or bonus as a smaller amount and then providing an additional contribution to savings. Although the total gain is the same, the second scenario is framed more positively.
- Automatic increase in savings rates – Increasing your savings rate over time is important because the value of money changes. Making it automatic just creates discipline around saving.
Too much choice is paralyzing
In another TED Talks video, Sheena Iyengar talks about how too much choice affects our decision making process.
Iyengar make a compelling case for why too much choice is paralyzing. We already make a lot of choices in life. Giving people too many choices is actually counter productive, especially when there are more than 10 options. It gets even worse when the chooser is ill prepared to make a choice (not enough information).
The power of visualization and saving
One interesting part of the video is a study Sheena did with Shlomo Benartzi and Alessandro Previtero, where they looked at employees working at ING during an enrollment session for their 401k plan. When employees were asked to think about all the positive things that would happen in their life if they saved more, enrollment increased by 20
Are we too optimistic about our future savings?
Professor David Laibson at Harvard suggest that we are overly optimistic about our future savings. We plan to improve our behavior but few people do anything.
- 68 out of 100 workers said they were saving too little
- 24 out of 100 workers said they were going to increase their savings in the next 2 months
- After 4 months only 3 of the 24 people actually increased their savings
Another example Laibson describes is where 100 workers volunteered to come to an educational seminar. Immediately after the educational seminar, they were polled and the all had fantastic intentions:
- 100% who were not participating in a workplace savings plan said they were going to join the plan in the near future. (Only 14% joined)
- If they were already in the plan, 28% said they were going to increase their contributions (Only 8% increased contributions)
- 47% said they were going to review and change their investment selection (Only 15% changed their investments)
People who did not go to the educational seminar had the exact same results which sadly suggests that education did not make a difference.
The battle between your present self and your future self
In another video, Daniel Goldstein suggest that most of us don't really want to save. They simply want to consume and spend and enjoy life for today.
We can see clearly that the present self is winning and has been winning for quite some time. Savings rates have dropped since the peak in the early 1980’s and the retirement gap continues to widen an be a major concern.
Putting money forward into the future requires some ability to visualize and look into the future to see what putting money forward will give you. This is not easy to do but having the ability to see the future self helps people to work towards it.
My Five Cents
These videos show that psychology and emotions are very powerful when it comes to saving money, investing and making good financial decisions. Here's what I got from these videos:
- Automatic Enrollment – Opt out rates are only about 10% which means you will have about a 90% participation rate. I find about 70% participation so auto enrollment should increase participate.
- Procrastination is the hurdle. Put the good outcome before the hurdle instead of the good out after the hurdle.
- Move both outcomes before the hurdle. You must make a decision one way or the other.
- Make it simple to enroll
- Help educate, not on the choices but the outcome of saving money. “What will the money you save do for you in the future?”
- Frame the savings not as a loss of income but as an addition to your spending.
People recognize the problem, they have good intentions to change behavior but in the end, rational people do irrational things.