Want to have a comfortable retirement? Stop focusing on the stock market and focus on yourself instead.
Simple choices — putting money aside for retirement, increasing contributions once a year, holding tight during market volatility — are what drives investors to success, said Daniel Crosby, author of “The Laws of Wealth: Psychology and the secret to investing success” (Harriman House). “Despite the unequivocal truth that investor behavior is a better predictor of wealth creation than fund selection or market timing, no one dreams about not panicking, making regular contributions and maintaining a long-term focus,” he said.
One example: the S&P 500 SPX, -1.45% has had an annual total return of 11.1% over the last 30 years, but the average stock mutual-fund investor has earned less than 4%, due to mutual-fund expenses and poor timing.
Enter behavioral finance.
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Behavioral finance is the melding of economic theory and psychological and cognitive theory — how and why people make the financial decisions that they make. Crosby earlier this year launched a certificate program in applied behavioral finance with Green Consulting, which financial advisers can use to help their clients make decisions and follow through on those decisions to meet their goals.
The problem? People are “psychologically ill-equipped” to invest in risk assets, even if they need to do so. They also don’t save very much for retirement, possibly because they don’t think they need to yet or because they can’t afford it. Not all Americans have access to tax-advantageous retirement accounts, either. Companies with employer-sponsored plans are helping more though, with strategies like automatic enrollment and auto-escalation of retirement contributions, concepts Nobel Prize winner Richard Thaler cocreated. Thaler’s work, which focuses on behavioral economics and getting people to save more money for their futures, could have accumulated billions of dollars in retirement savers’ accounts in the last decade.
Crosby spoke with MarketWatch about how behavioral finance affects retirement.
MarketWatch: How important are behavioral finance concepts to retirement planning, and can you give an example?
Daniel Crosby: Behavioral finance is crucial to retirement considerations because so much of our wiring is for immediacy and not for delayed gratification. As recently as a few hundred years ago — which is the blink of an eye evolutionarily — the average human lifespan was 35 years old. There was no need to plan for the future, you just did the best you could moment to moment. In a very real sense, those who survived to pass on their genes were the ones who were the most concerned about surviving in the moment and a big part of that is risk and loss aversion. Those tendencies, that served our forebears well, are not well suited for the new milieu in which we find ourselves. Today, a lot of those immediate threats have been eliminated through medicine and nutrition, and we need to think about living in retirement for as many years as we worked in many cases. In order to effectively plan for retirement, we need to grasp the reality that there is a “future self” that is just as real and just as hungry as our current self. This requires a level of projection and extrapolation that doesn’t come naturally to us.
MW: At what point might it kick in that we are, essentially, on the hook for our own future (monetarily speaking)?
Crosby: Well, we know that the brain is developing well into the mid-20s with the prefrontal cortex not being full online until about age 25, but that still overestimates how fully tuned in most people are to the realities of retirement. I liken it to dying. Even small children know, cognitively, that they will not live forever. But this isn’t a very immediate reality and they aren’t necessarily doing much to prepare for or protect against death. In fact, they can act as though they are invincible even though they have a shallow, cognitive understanding of the reality of death.
Retirement is the same way. Most adults understand at some level that they need to retire and that they won’t work forever, but whether that realization is visceral enough to translate into action is another story entirely.
MW: How can we be better about acting on our need to plan our retirements?
Crosby: Step one is around creating a visceral, felt need to act. This will look different for different people but might include spending time with aging relatives to get a good look at what life will be like for us one day, talking to a parent or grandparent about what they wish they had known, or even just reading articles on the financial realities of retirement.
The second step is around automating and making it easy. Maintenance of the status quo is a human tendency that can be co-opted for good. The more we are able to automate good saving and investment behavior, the less we will think about it and the easier it will become. Humans tend to dramatically overestimate their willpower and those planning to save for retirement by choosing to do the right thing themselves, month after month, are likely to be sorely disappointed.
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MW: The concept of retirement used to be more along the lines of relaxing on a beach, far from an office building, but these days people are working well into those traditional retirement years, sometimes out of necessity. Do you think this new perception of retirement has changed the way people prepare for it?
Crosby: The first thing that is changing our perception of retirement is the scientific study of happiness. Every rigorous examination of happiness and well-being has hard work somewhere squarely in the middle, which runs contrary to some more two dimensional models of happiness. What we’re finding is that even when people are able to retire from work it may not always be in their best interests to do so entirely inasmuch as work is a create source of relationship building and mental stimulation.
A second consideration is that this “escape to the beach” mentality assumes that you hated your job so much that you demand absolute distance from it in retirement and that’s a sad commentary on how you spent 30 to 40 years of your life. Instead, of working at a soul-sucking job for decades and then escaping, I think that people are increasingly seeking out work that is both personally and professionally fulfilling. This allows for comfortably working longer which is also consistent with the need to work more years to keep up with our expanding longevity.
MW: How important is it to think of or visualize exactly the type of retirement you want to be successful in achieving it?
Crosby: Visualization is a part of cultivating an appropriate sense of urgency about retirement, but I’d say that it’s about more than just dreaming about the boat that you want. In order to be effective, I think people need to think about not only the life that they want but the one that they want to avoid. Psychologists have shown that we are more motivated to avoid loss than to seek gain and so just as surely as we dream about the boat, we need to also visualize the difficulty of just squeaking by if we aren’t adequately prepared.
