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Behavioral Finance

How Behavioral Economics Can Save You Money

First, a radical idea; then, a raging trend; now, accepted wisdom: We’ve all heard of the discipline of behavioral economics, but what does it actually mean for individual investors?

Articles by Betterment Editors

By the Editorial Staff
Betterment Resource Center  |  Published: April 8, 2013

Have you ever put yourself on a strict diet, only to postpone it to next week when faced with a piece of birthday cake in the office?

Have you ever made an impulse buy in a retail sale, only to remember later there’s a reason you never buy tweed (you inherited your mother’s hips)?

Do you ever experience moments of surprise at your inability to get things done – “How have I not replied to that email from Aunt Marleen?”

Have you ever held your tongue at a dinner party because everyone had the same opinion on [insert latest political issue here] and you didn’t want to disagree in case you were wrong?

These are just some examples of behavioral biases at work. If you answered “no” to every question – congratulations – you have excellent willpower and must lead a very organized and successful life (which probably annoys the hell out of all your friends, if you have any*).

Behavioral economics can save you money

For the rest of us**, some or all of these scenarios will be familiar. We come to understand that there’s the rational, sensible way, and then there’s the human way: Life happens, we get busy, we get scared, we become influenced by popular opinion; or we become enticed by whatever we hold in our immediate attention.

Hey, You’re Only Human

It probably won’t come as a surprise to learn that behavioral biases occur in all parts of life, particularly where money is concerned. Cold, hard cash can confuse a soft, warm heart. Or in other words: We get emotional when it comes to money.

While we certainly aren’t rational, it’s actually quite simple to predict – and pre-empt – behavioral biases. Here are a few that are common to investing:

Problem: Overconfidence Bias

On a scale of one to ten, how would you rate your driving skills? Most likely it’s a seven, and you’re not the only one. But someone has to be wrong. Statistically speaking, it’s impossible for most people to be above average. Overconfidence bias exists in investing too. People think they can do better than the market when they invest on their own, but on average most actually do worse.

There are other reasons we do badly when we invest on our own; we pick stocks using limited information like selecting only those we know or those that are closer to home (familiarity bias) and we stubbornly hold onto stocks because the current share price is beneath the purchase price (anchoring).

Solution: Match the Market

In reality, even the professionals don’t have all the info (or the crystal ball) necessary to time the market. We can never know what the market will do in the short-term; we can only invest in its long-term growth, and mitigate risk where can.

Investing in a diversified portfolio of thousands of companies both local and abroad – like the one we invest in at Betterment – means you will feel less of an impact when any one individual company’s stock falls.

Problem: Empathy Gap

As well as overestimating our ability to time the market, we tend to overestimate how comfortable we will be with risk in the future. When asked to dance in public in front of strangers in a week’s time, people volunteered, but when it came to the crunch, they chickened out.

Despite knowing that buying at the top and selling at the bottom is a losing strategy, most people find it extremely difficult to remain invested when the market drops. Time after time, those who invest in a down market do well when it recovers. So how do you overcome the fear and stay in the market?

Solution: Set & Forget

Hiring a financial advisor to talk you through the rough patches is one way – an expensive way – to keep calm when things get rocky. Try instead, to create a system that doesn’t require your input. This is similar to the “set and forget” approach, where you make all the right decisions as your most rational self, and avoid the situation where your stressed self must make a call. This gets even better when investing with Betterment, because when you set and forget, we actually continue to reinvest dividends, rebalance, and keep track of your goals.

Problem: Short Term Gratification

The empathy gap makes it hard for us to imagine how we’ll react when we’re stressed; it also makes it hard to even care about the future. Studies have shown that thinking about a future self is akin to thinking about a stranger. It is no wonder the short term needs take priority over the long term.

Solution: Goal Setting

Visualizing your future life and actually creating tangible goals is one way of making it more “real”. Creating big, scary goals is fine, but breaking it down into smaller, short-term goals will help you stay on track. Betterment’s advice feature – which let’s you know if you’re on-track or off-track – helps you better visualize the future and the impact of the decisions you make now.

Problem: Reliance on Willpower

Like Aunt Marleen’s email that remains in your inbox; depositing, rebalancing, and remaining properly diversified, are all things easily forgotten.

To make matters worse, it gets harder to resist something the longer you try to. Willpower loses its edge.

Solution: Automation

Instead of relying on your unreliable willpower. Automate all the hard things.

If you’d like to learn more about behavioral economics for free, check out Dan Ariely’s course on Coursera – A Beginners Guide to Irrational Behavior.

*I take it back… I’m just jealous.

**The humans reading the post.

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