We all want to believe that given sufficient information we are able to make rational investment decisions.
Based upon 20 years of research into the psychological aspects of investing, the reality is quite different.
Christopher HopkinsA recent paper from the National Bureau of Economic Research estimates just how much the average investor forfeits in retirement savings thanks to two psychological impediments: present bias and exponential growth bias.
Modern financial theory depends upon the assumption that in the aggregate, investors make rational decisions with known information. In fact, we make lots of mental errors. Investigators have identified a host of "biases" or psychological barriers that impede financial decision making. These instincts, hard-wired into our brains, served us well in prehistoric times when the sound of a wild tiger demanded an immediate response. Fight or flight.
Today, we rarely confront the imminent risk of being torn apart by wild beasts. But these survival instincts now impede our financial decision-making and frequently lead to sub-optimal or even detrimental financial choices.
The NBER paper looks at two important biases and how they can discourage retirement savings at exactly the wrong time. With the demise of traditional pensions and the heightened responsibility of individuals to fund and direct their own 401(k) accounts, overcoming these biases is especially important.
"Present bias" is the tendency to give more weight to options with earlier payoffs over longer-term alternatives with higher rewards. NBER analyzed two surveys, and discovered that 55 percent of retirement savers displayed this bias.
An investor might intend to deposit a pending tax refund into an IRA account, but decides to spend the money on current consumption instead when it finally arrives. This bias can manifest itself in procrastination, for example by putting off participation in a 401(k) that would generate greater financial security but whose ultimate reward is delayed.
"Exponential bias" is the widespread lack of understanding of compounding in investment returns. Less than 25 percent of investors correctly understood that returns grow exponentially (rather than on a straight line). And seven out of 10 investors significantly underestimated actual returns. This bias leads to lower rates of saving and investment in retirement accounts since the saver does not fully appreciate the power of compound returns.
Taken together, these biases cost retirement savers a lot of dough. According to the authors, these two factors reduce retirement savings by at least 12 percent, a significant deficit that would make a real difference once the paychecks stop.
The study adds to a long list of behavioral factors that impede returns. Confirmation bias, for example, is the tendency to exaggerate recent decisions that worked out well while mentally discounting unsuccessful trades.
Loss aversion is the very human instinct to overweight potential losses but underweight potential gains leading to bad investment decisions.
All human beings are subject to biases. Professor Dan Ariely of Duke University is an expert on cognitive biases and has written extensively regarding psychological factors leading to investing mistakes. An ardent user of purported cold remedy Airborne, Professor Ariely acknowledged his own behavioral bias in one of his books after the product was proven to be ineffective and its makers assessed a $23 million fine for falsely claiming the product shortened or prevented colds. The placebo effect is a powerful force, as the brain wants to confirm what it already believes. Similarly our investment biases are difficult to defeat even when we know better.
But the effort is well worthwhile. The authors estimate that completely correcting for these two cognitive errors would place an additional $1.7 trillion in the pockets of retirement savers. That's not chump change.
Christopher A. Hopkins is a vice president and portfolio manager for Barnett and Co.