Why You Find it Difficult to Plan Long Term and Start Saving for Your Retirement
Traditional economic theory underlines that rationally, where in throughout your lifecycle you will borrow when young, save in middle age and builds wealth, and spend your savings in old age.
In truth, you do not act rationally when you come to plan long term. Evidence from behavioural economics research shows that like most persons you are likely to be bad at committing to save for retirement. Procrastination, myopia and inertia lead many persons to postpone or avoid making the commitment to save sufficiently for the long term even when they know that this is ultimately in their best interest.
Indeed, you know you should save, and have the best intentions of doing so but, when faced with complexity and choice overload, you are likely to decide to ‘do it tomorrow’. At the same time, you are also likely to exhibit a strong ‘status quo’ bias.
There are a number of triggers that influence your behaviour. Understanding such behavioural responses in financial decision making is important for us as it impacts the successful design of investor education and financial strategies.
The Final Report (FR09/14) on ‘Strategic Framework for Investor Education and Financial Literacy’ issued by the Board of the International Organisation of Securities Commissions in October 2014 identifies the following as the most significant of your behavioural responses in financial decision making:
- Ambiguity aversion – the desire to avoid unclear circumstances, even when this will not increase the expected utility.
- Anchoring and adjustment – an initial value or starting point influences the final decision. The anchoring effect decreases but does not vanish with higher cognitive ability.
- Availability heuristic – people judge the frequency or probability of some events on the basis of how easily examples or instances can be recalled or remembered.
- Choice preference – too many options inhibit or overwhelm selection decision-making.
- Confirmation bias – people use data selectively to agree or confirm their existing views. Investors with a stronger confirmation bias also exhibit greater overconfidence.
- Conflict disclosure – disclosing a conflict of interest may make it more likely that the conflict will actually occur as it increases levels of trust.
- Disposition effect – the propensity of an investor to sell winners too early and hold losers too long.
- Framing effect – a decision is influenced by the phrasing or frame in which the problem is presented.
- Herding – a phenomenon where many people take the same action. Information concerning the number of previous transactions in the market is particularly relevant to explain herding propensity among investors.
- Inertia – the default option becomes the de facto selection even if it is not the optimal choice.
- Loss aversion – people more strongly prefer to avoid small losses than acquire larger gains. Loss aversion is not invoked when spending money that is within an intended budget for purchases, but only when operating outside the intended budget. Loss aversion can actually be a motivation to invest to the extent that when people perceive a loss, they become risk – seeking as opposed to risk averse. When assessing a situation from the perspective of a potential loss, “loss framing” will occur. An investor on a losing streak, for example, may well decide that greater risk is necessary to achieve their target. See also “framing effect” in Other biases and effects related to financial decision-making.
- Myopic loss aversion – combination of loss aversion and a tendency to evaluate outcomes frequently. This leads investors to be more willing to invest a greater proportion of their portfolio in risky assets if they evaluate their investments less frequently.
- Overconfidence – people tend to trade frequently and hurt their own investment performance. Investors are more likely to be overconfident when they are less experienced as they learn about their true ability through experience. Investors with biased information processing behaviour in virtual communities are likely to trade more actively and realise worse performance due to their overconfidence. Overconfident investors, who show a better than average bias, trade more frequently.
- Present bias – the inordinate weight people place on costs and benefits that are immediate.
- Risk aversion – when individuals have the same level of financial education, there is no gender difference in the level of risk aversion.
- Temporal framing – people too heavily discount future benefits in lieu of present consumption.