Traditional economic theory suggests that investors are rational decision-makers and, therefore, markets are rational. Anyone who still believes that is doing so in the face of mounting evidence, both in research and real life, that defies the rationality of markets and people who compose markets. When it comes to investment returns, your biggest enemy is likely staring back at you in the mirror.
Saving money for a future that’s far off is cognitively hard for humans. Our brains evolved with three primary functions: To get reward, to avoid danger and reproduce. All our natural behaviors, even some that we consider character faults, were all honed for millions of years with the sole goal of keeping our ancestors alive long enough to reproduce. Our hard-wiring is poorly suited to the modern financial world where the younger you has to think about providing for the older you.
Overcoming Your Natural Tendencies
The first step toward a better financial future is recognizing that emotion is your enemy (registration). The path to a better investing world means things like automatic enrollment in employer defined investment plans, automatic increases as income escalates and better default investment options. A handful of employers get that, the majority do not. Therefore, you’ll climb that hill on your own and your emotions and biases will work against you at a every step.
Psychologists even home a name for this one, it’s called the Status Quo Bias. That sitting inertia is what makes it easy to favor a bigger paycheck today and imagine you’ll start saving for retirement later. The Status Quo Bias works together with another behavioral roadblock called Aversion To Ambiguity. People find the stock market confusing, they preferentially remember the times they lost money in stocks and all that provides powerful motivation to do nothing. The fact that 46% of Americans have no money in the stock market stands as silent testimony to mental power of Aversion To Ambiguity. The way to overcome this natural procrastination and status quo is to automate as much of your savings as possible.
Fear and Panic
Avoiding pain is hard-wired into our brains at a very basic level. When you touch something hot, your brain is already pulling that hand back before you are consciously aware you’re being burned. The pain you feel when you watch the stock market tumble is real. That pain leads to panic and panic leads people to lock in steep losses at the very times they should be investing more money. If you lose $100 the pain of the loss is worse than the elation you feel at gaining $100. The pain of loss is bad in two ways: It makes you sell when you should be investing and you hold onto a loser position when you should have dumped it and moved on. Pain feeds panic, panic results in poor financial decisions.
Guided By Peers
If you want a big house in a nice neighborhood, ask yourself why? If you’re really honest, the most likely answer will be because that’s how your peers live. Your friends, coworkers and family lived that way and it’s natural to feel that pull. Houses represent a huge investment, what economists call sunk costs. A fashionable home is the biggest single financial mistake most people make and, instead of admitting the mistake and selling at a loss, the majority will cling to that financial anchor, confident that the rising housing market will eventually bail them out.
Holding on to an anchor is not the way to get ahead. Follow your instincts and you’ll end up poor. Learn about how your brain can work against you and you’ll be taking the first steps toward a better investment future.