How behavioral economics can affect 401(k) savings
The importance of personal financial responsibility, and the role you play in preparing for your own future financial well-being, cannot be understated. And even though Americans are asked to take charge of their financial health, studies show that we don’t always act in our own best interests.
Workers face a multitude of problems when asked to make retirement-related decisions, whether simple or complex. And that’s where Behavioral Economics come in. Behavioral Economics focus on how and why people make irrational decisions, and understanding Behavioral Economics may help people make more rational choices to increase their savings for retirement.
Many individuals, whether they realize it or not, apply the concept of heuristics, a fancy name for “rules of thumb,” into their decision-making process. They use mental shortcuts, like “save 10 percent of your paycheck for retirement” or “take the number 100 and subtract your age to give the percentage of your portfolio that should be invested in stocks.” Heuristics may simplistic, but they’re not rational conclusions and can lead to errors called cognitive biases.
Four cognitive biases you should avoid in your 401(k)
1. The Follow the Herd mentality
We’ve all heard the question, “If your friend jumped off a bridge, would you do it too?” at some point in our lives. While the question is hypothetical, it showcases a dangerous Follow the Herd mentality. Most people don’t want to get left behind, so when they hear a family member or friend is successfully growing their retirement savings, they’ll try to mimic the strategy. However, each individual situation is different and what works for one person may not work for everyone. Jumping off the bridge with everyone else just isn’t worth the risk.
2. The Over-confident Investor
Many people tend think they are better at picking investments than they really are. Maybe they have had some previous wins, or maybe it was just beginner’s luck, but it’s probably not sustainable. And either way, they’re not likely to become the next Jim Cramer. Investments can be complicated and tricky to choose, so when in doubt – seek investment advice.
3. The Over-reactor
For some, the stress and volatility of the stock market can get in the way of proper decision-making. When many people hear on the news that markets are trending down or that there’s mayhem on Wall Street, they quickly sell, sell, sell. Before making any rash, heat-of-the-moment decisions, call an investment advisor for a second opinion.
Saving for retirement is a marathon—not a sprint. It takes years and years to successfully grow a retirement nest egg, yet many people put more thought into how decisions today will impact tomorrow. Instead, focus on being more concerned how decisions made today will affect retirement, regardless of how far down the road that is. When investing, it’s important to take a step back and think about the long run; this will help you prepare a plan that meets your long-term goals.
Behavioral economists tell us to eliminate “rules of thumb” and replace the guidelines with solid, well thought-out advice. Investment strategies should consider each individual’s age, goals, and risk tolerance, so it becomes clear that there’s no one-size-fits-all solution. Prudent decision-making is paramount when it comes to retirement strategies and investing, and being aware of cognitive biases while preparing for your future can ultimately make the difference between financial illiteracy and retirement readiness.
Ryne Lambert, MBA - Financial Services Representative Team Lead - firstname.lastname@example.org - 800.236.7400 Ext. 3491
Ryne is a subject matter expert on 401(k), retirement savings, investments, participant advice, personal finance education and behavioral finance.