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Your brain is not necessarily set up in a way that makes it easy to plan a secure retirement. You have cognitive biases — faulty ways of thinking that are unfortunately hardwired into your brain — that work against you.
Wikipedia lists 185 different kinds of cognitive biases. While they are all probably somewhat damaging to your well being, below are nine biases that could hurt your future financial security.
Being aware of these biases can help you do a better job planning and saving for your retirement. Below we also offer specific tips for overcoming each of the misguided thought processes.
Ambiguity Effect
Neurosis is the inability to tolerate ambiguity. – Sigmund Freud
The ambiguity effect reflects a tendency to avoid decisions or options where unknown information makes it hard to predict an outcome.
Examples: When planning your retirement, you need to “know” how long you will live, future inflation rates, investment returns and other factors that are actually unknowable. Not being able to “know” this information can make planning feel ambiguous and impossible and many many people just avoid it altogether.
You might also fall victim to the ambiguity effect with investments — you might opt for bonds where the returns are considered safe rather than stocks which are more volatile but are likely to have higher returns.
Overcome the Ambiguity Effect: One way to overcome the ambiguity effect for retirement planning is to assign optimistic and pessimistic assumptions — based on historic norms — for the unknowables. Using best and worst case scenarios makes it a little easier to get your hands around the unknowables. The NewRetirement retirement planning calculator lets you do exactly that.
For retirement investments, you might want to tailor your asset allocation strategy to your needs and wants — investing money for needs in conservative vehicles and money for wants more aggressively.
Anchoring
Change your mind and you can change the world (or at least your future retirement.) – Norman Vincent Peale
Anchoring is the impulse to rely too heavily on one piece of information when making decisions.
Example: When planning for retirement, most people anchor on how much savings they need. However, savings is just one aspect — often not even the most valuable aspect — of your retirement security.
When you start social security, whether or not you’ll downsize, figuring out how to turn savings into retirement income and understanding your future spending needs are probably more important than (and certainly impact) how much savings you need.
Overcome Anchoring: Educating yourself about all the factors that impact your retirement financial security is a good step to overcoming anchoring.
- To start, you might want to explore these 15 scenarios that impact your retirement plan and actually experiment with your own numbers in a detailed retirement planning calculator.
Bandwagon Effect
Birds of a feather flock together.
Bandwagon effect is the inclination to do things because many other people — particularly your friends and family — do them.
Example: Research shows that people who have friends who exercise and eat well are healthier themselves. The same is actually true of retirement planning. People who have friends who are knowledgeable and proactive with their finances are more likely to be financially stable themselves.
Unfortunately, the reverse is also true. And, because the vast majority of people in the United States have an extremely low financial IQ and according to a report from Charles Schwab only a quarter of people have a written retirement plan, the bandwagon effect is probably working against you.
Overcoming the bandwagon effect: Maybe you could start a “retirement club?” A retirement club is kind of like a book club but you discuss retirement topics instead of novels. It can provide a friendly forum for learning about financial topics. Best of all, if both you and your friends are engaged in retirement planning, then you are using the bandwagon effect to your advantage and stand a better chance of being financially successful.
Choice Supportive Bias and Confirmation Bias
Beware of false knowledge; It is more dangerous than ignorance. – George Bernard Shaw
According to Wikipedia, choice supportive bias is the “tendency to remember one’s choices as better than they actually were.” Confirmation bias is similar in that we seem to be predisposed to focus on information that confirms our preconceptions.
Example: Choice supportive and confirmation biases seem to be particularly dangerous when it comes to investments. Imagine you get a stock tip. When you research that tip, you are likely to seek information that confirms your tip rather than get a more unbiased perspective.
Overcoming Choice Supportive and Confirmation Biases: There are a few ways to deal with these biases with regards to investments:
- Have an Investment Plan: An investment plan — or asset allocation plan — is a written document that outlines exactly why you are invested in what way and what you will do in a variety of future scenarios. This prevents you from making rash decisions.
- Work with a Professional: Many people simply can not keep their emotions out of their financial decision making. A financial advisor can act as your rational brain and keep your investments on track for the long term.
Disposition Effect
Risk comes from not knowing what you are doing. — Warren Buffet
The disposition effect is actually specific to investments. It is the tendency to sell an asset that has risen in value and resist selling an asset than has dropped in value. This is not actually the best strategy. It is just a bias.
Example: I am actually guilty of this. I am currently holding $3,000 of some small company that I bought years ago (like 30 years ago) at $7,000. All indications suggest that this company is headed for bankruptcy and won’t last long. However, I don’t really want to sell it. Sure, it’s small potatoes, but I still spend time thinking about it and tracking it and really I should just get rid of it.
On the other hand, I am tempted to take my short term gains on Facebook this week — even though I actually think that Facebook is a good company to hold for the long term.
Overcoming Disposition Effect: As with confirmation bias, avoiding emotional and irrational decision making is extremely helpful:
- Have a written investment or asset allocation plan
- Rebalance to retain desired asset allocation structures
- Work with a financial planner
Endowment Effect
A bird in the hand is worth two in the bush.
The endowment effect is the phenomenon that people “demand much more to give up an object than they would be willing to pay to acquire it.” People think that things they already own — especially things with emotional meaning — are more valuable and tend to want to hang on to them.
Example: Homes are usually a person’s most valuable asset. However, the majority of retirees are somewhat wary of downsizing or tapping into that home equity — even if they might need or want the money.
Sometimes the reluctance is due to wanting to retain the asset for heirs, other times they want to stay where they have always lived (even if it is not suitable for their current needs). Whatever the reason, homes are an emotionally charged asset so the the endowment effect is probably an extremely powerful force.
Overcoming the Endowment Effect: Being aware that your brain has this tendency to want to keep what it already has can probably help you behave more rationally. Making lists of the pros and cons of retaining an object or asset can also help you make a more informed and mindful decision.
Ask yourself questions: If you didn’t already own this, how much would you pay for it? How much effort would you put into acquiring it?
Continuing with the housing example, making a list of everything you could gain from selling your home — a better lifestyle, lower cost basis, earlier retirement or being closer to family — might help you get over the endowment effect.
Try out different what if strategies for tapping home equity when you use the NewRetirement retirement planning calculator.
Money Illusion
Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair. – Sam Ewing
Money does not have intrinsic value. The value of money resides in how much it can purchase — which changes over time.
The money illusion is the tendency people have to think of the nominal value (the numerical amount) rather than the purchasing power of that money.
Buying power — how much you can buy — is more important than how much money you have. And, the purchasing power of your money in retirement is more important than the balance of your accounts.
Example: How much is $1 worth? Well, ten years ago, a dollar could buy a candy bar. And, it might seem like $1 would still buy a candy bar, but the reality is that the average price of a candy bar is more than a $1.50. Nevermind the fact that it cost 5 cents back when most of us were kids.
The money illusion can be really confusing to people, but it is critical to understand this concept — especially with regards to inflation and inflation’s potential impact on your retirement finances.
Think about your investments. If you are getting a 6% return on investments, but inflation is rising at 3.5%, then the real value of your ROI is only 2.5%.
Overcoming the Money Illusion: When planning retirement, it is critical that you factor inflation into your calculations.
A good retirement planning calculator will project inflation rates and factor that into your results.
- The NewRetirement retirement planning calculator actually allows you to set your own optimistic and pessimistic assumptions for retirement and try different what if scenarios with these numbers to help make the money illusion concept very real. Immediately see how your finances shift every time you change inflation rates or any other number in your plan.
Present Bias
Present bias is the tendency we have to value the moments that are closer to the present than those farther in the future.
It is not in the stars to hold our destiny but in ourselves. — William Shakespeare
Example: It is a well documented phenomenon that you are more likely to spend money this month on something that gives you pleasure now rather than save that money for your future self. Present bias is one of the BIG reasons that retirement savings is so difficult for so many people.
Overcome Present Bias: One way to overcome this bias is to imagine or even view a picture of what you might look like as an old person — even a really old person. Research indicates that if you can truly visualize yourself in the future, then you are more likely to save money, eat better, exercise and generally plan to take care of your future self.
Status Quo Bias
This is the impulse to keep things the same. It is more comfortable to keep going as you always have than to make any kind of big change. In fact, sometimes abandoning the status quo takes the proverbial leap of faith.
Life is traveling to the edge of knowledge, then a leap taken. – D.H. Lawrence
Example: While we are all pretty excited about retirement, it can be awfully hard to take the leap and actually stop working. Part of the difficulty can be attributed to our desire to just keep the status quo.
Overcome the Status Quo: Here are a few tips from Coaching Positive Performance about overcoming the status quo bias:
- Review past big changes or challenges — this will remind you that you are capable of transformation.
- Break it up into smaller actions — Maybe you shouldn’t retire all at once, how about taking a long sabbatical first or going part time for awhile.
- Identify obstacles — You need a solid plan if you are going to retire. Documenting a detailed retirement plan can help you identify stumbling blocks and how you will overcome them. Or, explore some of the likely things that might go wrong in your future — and plan for them.
Use the NewRetirement Planner to Outsmart Your Brain
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