Here are three problems most people face in behavioral finance, originally proposed by Shlomo Benarzi and put into plain English by Lione of the blog cheerfulegg.com;
- Present bias: We know we should be saving, but we don’t do it today. We’ll make all these resolutions that we’re [going to] save more next year, next month, next week, whatever, but it never works. It’s always a lot more fun to spend more today, and put off what we know is good for tomorrow.
- Inertia: People are lazy. And don’t even think that you’re different from the rest of us, because you’re not. Even checking a box on a form, is way too much effort for most people, even if it means saving someone’s life. Germany has an opt-in program for organ donation where you would have to check a box if you would like to donate your organs. Contrast it to Austria, which has an opt-out program, where you would check a box if you don’t want to donate your organs. The result? 12% of Germans take up the program, while a whopping 99% of Austrians agree to donate their organs.
- Loss aversion: We hate losing stuff. When it comes to savings, people amazingly frame this as a loss because they have to cut their spending today.
So where does that leave us? The trick to overcoming all of these problems is to (surprise, surprise) adopt an automated system that saves on a regular basis, and whenever you have any income increases. Since saving more tomorrow is easier than saving today (present bias), we first make the commitment to save a certain percentage of our income… tomorrow. Or next month. Whatever. We then commit to it by setting it up with our bank.
Once it’s set up, that overcomes our problem of inertia, because it takes [a lot] of effort to cancel that commitment. So we’ll automatically be saving without any effort at all. And finally, by committing to save a fixed percentage of our pay rises, you’ll be taking care of loss-aversion by allowing yourself the luxury to spend part of your pay rise, while saving the other part of it.