We often inhibit our retirement savings efforts because of our biases. These biases cause us to make emotional money decisions that hurt our retirement savings over time. What’s worse is that we rarely catch ourselves in the moments when we are making biased decisions.
Usually, two prejudices impact our investment decisions and retirement savings. These biases include immediacy bias and exponential-growth bias.
Many Americans suffer from an immediacy bias, which is a tendency to prefer immediate benefits versus potentially greater satisfaction over time. The National Bureau of Economic Research conducted a survey, simply asking people if they would prefer receiving “$100 today or $120 in 12 months”. More than half of the respondents chose to have $100 right away.
Often, we ask a similar question when speaking with groups of millennials and have found that almost all prefer receiving the money today rather than waiting a year to receive even more. Patience is the key to investing and saving for retirement, and the immediacy bias is its principal enemy.
It’s common to see people start panic selling stocks as markets become volatile. Such action is partially influenced by the present bias. The sellers make hasty decisions as they face the chaos of the moment and lose sight of future profitability.
This is also applicable to workplace retirement plans such as 401(k) plans. If you have tight personal finances or an inadequate understanding of investments, money in your hand today might seem more tangible than the money that might be earned years from now. As a result, you may not invest in your employer-sponsored retirement plan, thus eliminating the potential for your money to grow over time. This leads you to the exponential-growth bias.
Exponential-growth bias is not understanding the sweetness of compounding. The best way to learn about the potential of compounding is to take time to understand the long-term savings potential of tax-deferred retirement accounts. People don’t understand this mainly because they lack financial literacy.
In short, you should understand that assets in a retirement account don’t grow by a fixed amount each year. Instead, they gain compounding interest. This means that your accounts will not only gain interest on the amount that you have contributed to them, but the interest they have earned in the past will also earn interest.
The compounding rule applies here. Many people know the Rule of 72, which states that for an asset to double in value, you can divide 72 by the interest rate on the asset. This is a simplified yet effective way to estimate the doubling of an asset’s value and can be applied to investments.
Although the Rule of 72 is popular, we should also keep in mind the 2-20-50 Rule. This states that any asset that increases in value by just 2% each year for 20 years will be worth about 50% more at the end of those 20 years.
Exponential-growth bias causes people to neglect the effects of compound interest and not save enough money. People do not understand compound interest and therefore do not understand the value their money will have in the future.
Biases can defer you from saving
Biases are easy to harbor and easier to fall back on. The exponential-growth bias paired with the immediacy bias often causes people to not save enough money because they see having money in hand now as more valuable than having it in the future.
Sometimes, even good retirement savers and long-term investors fall prey to biases. Challenge these biases if you want to have a winning financial portfolio. At the end of the day, it is important to understand that if everyone eliminated their biases, the nation’s total retirement earnings would be increased by at least 12% because people would invest more money while they were young and take advantage of compound interest.