Home
What did you do with the last mailing from your retirement plan?
If you chucked it in the trash without looking at it, you are not alone. Most people don't save enough and then pay very little attention to their investments. Let's face it: Figuring out how much you are paying in fees, or whether your assets are compounding at a rate high enough to sustain you through retirement, is just not that much fun.
Americans pay a price for this lack of attention. The average 401(k) in 2011 held $98,481 in assets. The average IRA account balance in 2011 was $70,915. You don't have to be a math whiz to realize that those balances ought to serve as big red flags. About 53 percent of households are "at risk" of not having enough to maintain their living standards in retirement, according to the Boston-based Center for Retirement Research.
But there's help available. New research from the field of behavioral finance can be applied to your retirement plan mailing. Just as people who lose weight hang a bikini on the doorknob, learn to avoid the bread basket at dinner and figure out how to overcome their own exercise excuses, investors can use mental devices to help themselves save more and pay better attention to their investments.
"The general idea really is that people have to practice evidence-based investing in the same way they practice evidence-based medicine," said Meir Statman, finance professor at Santa Clara University and author of "What Investors Really Want."
"I don't have to know what a physician knows, … but I know that vegetables do me more good than steaks without understanding all the physiology that goes into it."
Here, based on interviews with three experts on behavioral finance—Statman, Shlomo Benartzi of UCLA and Steve Utkus of the Vanguard Center for Retirement Research—are four key suggestions for how to be a healthier long-term investor.
1. Save more by imagining yourself into the future.
Not to put too bald a face on it, but most people are hard-wired to be bad at long-term investing. We live in the present and have a hard time sacrificing pleasures now to obtain future rewards. To overcome bias toward the present, some behavioral economists suggest that as you sign up for your 401(k) or make your IRA contribution each year, imagine yourself at age 70, drinking coffee in the park, traveling or buying a Christmas gift for your granddaughter. "It's the old parable of the grasshopper and the ant," said Utkus. "There are oversavers and there are undersavers."
Moral: If you're a grasshopper, recognize that trait in yourself and work to correct it.
2. If you believe you can win at the investing game by picking stocks or fund managers, remind yourself that you're playing against Warren Buffett.
Some people see investing as hitting a tennis ball toward a target. Because people tend to be overconfident in their own abilities, they believe they have the talent to hit it. In other words, they believe they have the talent to pick stocks or actively managed mutual fund managers. (If you think you're one of the rare people who is not prey to overconfidence, you should know that this is one of the most common and deep-seated cognitive errors. Consider this simple stat: 80-90 percent of drivers believe they are above average).
Many retirement plans reinforce the mistake of overconfidence by offering their participants a wide selection of actively managed funds. Plans offer an average of 19 funds for both participant contributions and for company contributions, according to the Plan Sponsor Council of America, and the funds most commonly offered are actively managed.
But research shows the majority of actively managed funds underperform the market. In reality, you (and those mutual fund managers) compete with millions of other people to hit the same small target at nearly the same time, and some of those other investors are as good as Warren Buffett. If you let go of the illusion you can win, you be more willing to embrace passive index funds and ETFs, whose lower costs can give you a leg up in long-term investing.
3. See time as a resource as valuable as money.
Transitions are hard for everybody, and people tend to avoid taking the financial steps they need to take when they are undergoing one. When it comes to investment decisions, many people tend to favor the status quo.
When they are nearing retirement, they don't take some common sense steps to prepare themselves, like gradually spending less in the decade before retirement, or even, when they do retire or downshift, rebalancing their portfolios and deciding on a sensible withdrawal rate. (One rule of thumb is 4 percent a year). Benartzi suggested that if you remember how much you value time, you might be more able emotionally to cope with the prospect of having less money—and therefore might bring yourself to the important task of actually creating a new budget.
"The mistake is thinking that money is everything," he said. "(People) get used very easily to spending more. … But we know that the correlation between money and happiness is very shaky. Perhaps people could spend a lot less and be happy."
4. Recognize stories of investment wins for what they are: fish tales.
We've all run into them: the guy at the cocktail party or the financial advisor who has written the book that claims to have the easy answer. They trip us up in two ways, by making us think it's possible to win at active management (see No. 2) and/or by persuading us that we should invest as they do.
Technically, this is the cognitive error of availability—the tendency to make judgments about events by how easy it is to think of examples. "It is just human nature that they are going to write about those investments that have done well," Statman said.
Maybe this person actually knows what they're talking about. But in general, people remember stories about the big fish they caught, not the hours they spent fishing or the small fish they threw back. People playing at the active management game will remember the one winning bet they made: They won't share the fact that their overall portfolio returned less than the market.
—By Elizabeth
