Most of us have a gap between what we should be saving for retirement and what we do save for retirement. We often don't act in our own best interest due to some hard-wired behavioural programming. Here we identify some of those bugs in our cognitive machinery and how to avoid the resulting behavioural pitfalls that damage our financial wellbeing.
How Much Should We Save?
Before the idea of retirement caught on in the UK around 1908 people were expected to work until they died or became physically unable to work. As we are living longer and the population ages there are less workers to pay for the pensions of those that retire and the terms are gradually becoming less generous. The retirement age is creeping up and there's talk of removing the pensions triple lock which ensures that the basic state pension rises by a minimum of either 2.5%, the rate of inflation or average earnings growth. The best way to ensure that you can retire, and that you can live comfortably, is to save yourself. Calculating how much you need is not easy but the BBC commissioned some research into the numbers and came up with the following:
The longer you delay the more it costs because you miss out on the wonderful effect of compounding. For a 25 year old the savings required to retire on £20,000 is £246 per month which is about 11% of the average UK salary. If you prefer M&S to Aldi and holidays in Tuscany rather than Bognor then you might need a larger retirement income of, say, £30,000. That would require saving 16% of your average salary from the age of 25.
There are lots of reasons why this is not an exact science. Inflation may spike in the interim, eroding the value of your investments. Markets may crash reducing the size of your pension pot. The average lifetime of people may increase so much that annuities (which use your retirement pot to buy an inflation-linked income until you die) will become much more expensive. But using reasonable numbers you should be thinking of saving in the range of 11% to 16% of your income as soon as you start to earn.
To save for the future you have to sacrifice disposable income today. That may mean forgoing the purchase of fancy cars, McMansions, the latest gadgets and luxurious holidays. However we seldom make the rational choice because of a hard-wired flaw in our thinking:
Given the choice between a reward today or in the future we vastly prefer the present, we prefer jam today over jam tomorrow
The experimental evidence for both humans and animals shows the same bias toward instant gratification. We tend to value rewards and consumption today far more highly than consumption in the future. Which of these would you prefer?
- £50 now
- £100 a year from now
And which of these two?
- £50 in 5 years
- £100 in 6 years
The majority of people will choose to receive £50 today over £100 in a year. But we are also inconsistent because almost all of us would prefer £100 in 6 years rather than £50 in five years. This is inconsistent because in 5 years time the second experiment becomes the first experiment but the answer changes! And yes, my choices were £50 now and £100 in six years too.
It turns out that preferring consumption today is rational but the degree of preference should depend on interest rates. The logic depends on having a risk-free rate of interest. If we know for certain that we can get a risk-free rate of interest then £100 today would be worth £105.10 in five years time. Conversely if we invest £95.15 today that would be worth £100 in five years. So the value of £100 in five years, £95.15, depends on this risk-free rate. When the rate is 1% we should rationally prefer £95.15 or more today than £100 in five years time. This brand of reasoning is called discounting and underlies the pricing of every financial asset on the planet. Behavioural economists disagree on the exact mathematical formula that penalises future rewards, some saying it's exponential discounting, others that it's hyperbolic discounting. But quibbling aside nobody would dispute the evidence that delay is a strong driver of reward preference and is a barrier to saving and investment.
Central Bank Policy Depends on Discounting
Central banks around the world operate on the assumption that our preference for consumption today depends on interest rates. When there is a financial crisis economic growth plummets. People stop spending in a recession as job security falters and they engage in precautionary saving in case they lose their income. To stop this spiral of gloom and get people spending again central banks cut interest rates. After the Global Financial Crisis in 2007/2008 there was a decade of essentially zero interest rates in the US, UK, Europe and Japan.
To see why cutting interest rates makes consumption today more attractive let's assume that the risk free interest rate is 0%. Money in the future would be worth as much as money today. We have very little incentive to save if this is the case so consumption in the present should be more attractive.
Share and bond valuation models also depend on discounting. A share's value is the sum of all its future free cash flows discounted at a rate that is made up, at least in part, by the risk free rate of interest. As the risk-free rate falls the value of stocks should, at least in theory, increase because their cash flows are being discounted less heavily. Bond prices will also increase for the same reason, and here the link is more direct. Bonds with longer duration will benefit most from a rate cut and suffer most from a rate rise.
Status Quo Bias
You've probably been sold products and services with a money-back guarantee. It sounds like you can't lose because if you don't like the product you will get your money back, but the vast majority of people fail to claim their money back due to the tendency to stick with the status quo. The same tactic is used to sell magazine subscriptions where there's a free trial, but you often end up receiving the magazine well past the free trial because you didn't get around to contacting the magazine to cancel the subscription.
This behaviour is not just laziness. There are many reasons why people prefer the status quo.
Take a look at the following two choices. Note that in the first one four investments are laid out with no status quo, all are new investments.
In the second example the first choice is the status quo choice because you inherit a portfolio which already has investments in it. You can probably guess how this way of presenting the same choices affected people's preferences...
This experiment, by Samuelson and Zeckhauser in 1988, found that people prefer the status quo i.e. they tend to keep the portfolio they inherited regardless of whether that is the better investment choice. Another interesting and useful observation is that the status quo preference strengthens as the number of alternatives increases.
Status Quo Bias May Be Rational
There are usually costs associated with changing your mind. For example if you are changing your portfolio there will be trading costs and taxes involved. This puts up a barrier to change even if the change improves your expected outcome. The act of finding a better alternative requires time and effort which is itself a cost. This is why more ergonomic keyboards have never gained acceptance. The Maltron keyboard, which is optimised to put letters that occur together in English words close together on the keyboard, is demonstrably more efficient than a QWERTY keyboard. But for most people keyboard switching costs are just too high if they have spent time learning the standard layout.
People may stay in low-paying jobs because the task of searching for a better job, interviewing for the job and the possibility of facing the emotional pain of rejection all add to the cost of the decision. Although price comparison sites help it is still difficult to wade through alternatives when finding the cheapest car insurance, the cheapest energy deal or the best holiday destination. Once we find a reliable service we are loath to pay the cost of reanalysis.
As investment is not part of the school curriculum in the UK few people know the bare minimum about investment. This means that the cost of educating oneself in the arcane details of portfolio construction is considerable. For the majority of people the educational cost of the decision to invest is simply too high and is likely to be a barrier to entry.
We Prefer to Stick & Lose Than Switch & Win
If we were completely rational then a fixed gain or loss should cancel one another. Experiments show that this is not the case when we think about money. A gain of +5% is far outweighed by a loss of -5%. For example if you were to play a coin-tossing game where tails would lose £10 how much would you have to be paid for a heads "win"? Most people are willing to play only if heads pays £20. This is because a loss mentally "costs" us twice as much as a win. In scientific terms the mental cost is called the utility, so the positive utility of a £10 win is half the negative utility of a £10 loss. And in the literature on behavioural investment this is called loss aversion.
Loss Aversion: People like to win but they hate losing much more.
If you like graphs then we can draw the shape of the utility found in experiments. This is from a paper by Tversky and Kahneman who are two of the people who founded behavioural economics. I've drawn in the dotted red line that a "rational" investor would use. Notice how the steepness of the line is greater for losses than gains. This utility kink neatly encapsulates the meaning of loss aversion. It explains why you need a reward twice the size of the loss in order to play the coin-tossing game
If we weigh alternatives relative to the status quo our loss aversion means we tend to stick with the status quo. This is because we would rather gain less with our current choice than entertain the possibility of loss with an alternative. Consequently we stick with the status quo even if it's not the best choice, a bias called the Endowment Effect by one of the founding fathers of behavioural finance, Richard Thaler. In his own words he describes the endowment effect as follows:
This notion that losses loom larger than gains captures what I have called the endowment effect: people generally will demand more to sell an item they own than they would be willing to pay to acquire the same item (Thaler 1980)
We Stick With Choices Where We've Invested Resources
Have you ever been in a situation where you felt you had invested too much to quit? Deep down, perhaps you knew that this wasn't rational, but you felt compelled to stick with what you've got. For example you could own an old car that costs more to repair each year, or a long-term relationship that is breaking down or a career that is no longer rewarding. The time, effort and money you have invested is called a sunk cost.
The sunk cost effect is a greater tendency to continue an endeavor once an investment in money, effort, or time has been made.
The sunk cost effect affects many aspects of investment. If we have a savings account with a very low rate of interest we may be tempted to stick with it even if we know that the rate of return would be better elsewhere. Or we may have invested in a poorly managed fund where we have diligently been depositing our capital and reading annual performance reports for years despite the fact that, net of fees, we would be better off with a passive fund.
As far back as the early 1800s the economist David Ricardo was fond of sharing his three golden rules of investment, the second of which was "Cut short your losses" and the third of which was "Let your profits run on". This advice is as popular as it is old, and should help rid you of any remorse for sunk cost or kink in your utility curve.
James Grant "The Great Metropolis" Volume 2, published 1838
We Can't Admit We Are Wrong
We tend to view ourselves as competent decision makers. If our current choices are not working out then we have conflicting information: how come we are a good decision maker but our choice isn't working? This conflict is called cognitive dissonance. Rather than admit we are not great decision makers we discard or suppress information that shows that a past decision was not a good one.
The fact that bank deposits are currently earning a negative rate of interest is often mentioned in the media. This means that by storing our wealth in bank accounts we are gradually eroding our wealth. One reason why we choose not to invest may be that we simply discard information about negative interest rates. Admitting that we are mismanaging our wealth would create cognitive dissonance with our self-image as prudent money managers. In the duel for truth inflation is being unseated from its horse and slain by our self-regard.
How To Avoid Underinvesting
The most effective way to ensure that we save and invest enough is to do so regularly. A very simple method is to invest a fixed amount each month. In the US this is called Dollar Cost Averaging, and in the UK we call it Pound Cost Averaging. The good thing about pound cost averaging is that it stops you accumulating cash while waiting for stocks to become cheaper. Trying to time markets is very difficult and something which the vast majority of us do very badly. Another benefit is that your fixed amount will buy more shares when they are cheap and less shares when they are expensive.
One drawback with pound cost averaging is that in a rising market, which tends to happen over the long-term if you buy stock market index funds, the return you receive would be higher if you invest a lump sum as soon as possible (if you have one!). As its name suggests pound cost averaging will give you the average return over the period that you invest. In a rising market your return will be better the sooner you invest. Also trading costs tend to be larger as a proportion of your investment if you trade in small amounts, so drip-feeding may cost more than investing a lump sum.
If you have a lump sum to invest the superiority of investing the lump sum all at once has been backed up in some analysis by Vanguard where they compared investing a lump sum with pound cost averaging in either a 100% equity, 60% equity 40% bond or 100% bond portfolio. They found that the lump sum investment approach performed better about two thirds of the time in the US, UK and Australian markets. In this table DCA stands for Dollar Cost Averaging.
The periods they used spanned several business cycles, which makes the results more credible, but data availability constrained their analysis: the results for the US range from 1926-2011, 1976-2011 for the UK and 1984-2011 for Australia. But if you don't have a lump sum then the choice of pound cost averaging is made for you!
A good way to motivate investment is to have a clear goal. That might be:
- Having enough money to retire comfortably
- Buying a house
- Paying for our children to go to university
The reason a goal helps is that it comes with a deadline. We know our retirement age, we know roughly when we want to buy our own house (usually as soon as possible) and we know the age at which our children will go to university. By having an investment horizon, one which is many years in the future, we may worry less about daily ups and downs in the stock market. Short-term dips in the stock market, such as 10% dips, stir the media into a frenzy but actually happen quite frequently and are seldom a reason to panic. The FTSE 100 spent a quarter of its time 10% below its previous year's peak over the last 33 years (10% is the loose definition of a market correction). We really can't afford to be out of the market a quarter of the time because we will miss out on some of the upside. Goals give us the ability to keep our resolve when markets go into reverse.
Engineer an Investing Habit
Investing and saving doesn't come naturally. You will have to formulate a plan, and you may find that automation helps. A budget will help you to work out how much you can afford to set aside each month, and then a direct debit can automatically transfer that amount into your investment account. The key thing is to become engaged with the world of investment, educate yourself in how the investment industry works and take control of your financial future. Your future self will thank you.
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