These three irrational behaviours could knock your retirement plans off course.
Our brains may trick us into saving less, spending more and feeling more confident in our decisions than perhaps we should. But to be a successful saver, it is critical to understand, and hopefully overcome, our psychological biases.
Here are three to be aware of:
1. Present bias
Have you ever delayed writing a report until the last moment, or had plans to tidy the kitchen turn into an afternoon glued to catch-up TV? That’s present bias at play.
Present bias makes us more likely to value immediate rewards over ones to be had in the future. It’s the reason why some people are more inclined to use surplus cash to indulge in a shopping binge than save it for the future. Indeed, many experts say that present bias is one of the biggest challenges to saving for retirement.
Unsurprisingly, it turns out there’s a scientific reason for this behaviour. Research has shown that there are two areas of the brain: one that is associated with emotions and the other with abstract reasoning.1 As you might have guessed, the emotional part of our brain responds positively to instant gratification. When given the choice of a doughnut now or fruit later, this part of your brain pushes you towards the doughnut.
“Our emotional brain has a hard time imagining the future, even though our logical brain clearly sees the future consequences of our current actions," says David Laibson, a professor of economics at Harvard University. “Our emotional brain wants to max out the credit card, order dessert and smoke a cigarette. Our logical brain knows we should save for retirement, go for a jog and quit smoking.”
One way to overcome present bias is to imagine or even view a picture of your future self.
2. Loss aversion bias
Loss aversion refers to our tendency to prefer avoiding losses to acquiring equivalent gains.
We are all hard-wired to be loss averse: it enabled our distant ancestors to survive in times when resources were scarce. But when it comes to investing, loss aversion can lead to an overly conservative strategy. Over a lifetime, it could cost you thousands of pounds.
This fear of losing money means people often place too much reliance on cash. Almost half of those who took part in a recent survey said they preferred not to take any risks at all with their savings, even if it leaves them short of money in later life.
While it’s natural – and often prudent – to try to avoid loss, letting that fear loom too large over your financial decisions could actually lead to the very thing you’re fearful of. A qualified financial adviser can help you stick to your goals and build an investment plan that caters for your level of risk tolerance.
3. Anchoring bias
Another financial challenge stems from a powerful force called anchoring bias. This is where we rely too heavily, or ‘anchor’, on one piece of information.
For example, someone in the market for a car may be focused on the condition of the paintwork. This fixation anchors their mind to only observe the car’s exterior, making them oblivious to issues such as the service history and fuel economy.
When planning for retirement, most people anchor on a target retirement date. However, this is just one aspect. Your State Pension age, your life expectancy and understanding your future spending needs are probably just as important.
Workplace pensions can also reinforce anchoring bias. Many employees assume that the minimum contribution rate under auto-enrolment is the ‘correct’ rate. In reality, those paying the minimum are probably not saving enough for the sort of retirement they are hoping for.
We all have deeply-ingrained biases that sit deep within our psyche. While they can serve us well in our day-to-day lives, they can have the opposite effect with investing. But by understanding and overcoming them, we may be able to improve the chances of a financially secure future.
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1 pr.princeton.edu, October 2004
Member since: 14th February 2012
I am a Shropshire based financial adviser who helps my clients manage their finances as effectively as possible. I specialise in investments, retirement planning and Inheritance Tax Planning.