Behavioral Finance

Why You Stink at Investing


Did you panic when markets tumbled earlier this year? Do you feel better now that they have stabilized? If so, you aren’t alone. The hardest part of being an investor – even a long-term one – is coming to terms with a terrible truth: we stink at investing because we are human beings. In fact, the very cognitive behaviors that distinguish human beings from other forms of life, can lead us astray. I recently spent time with Dan Egan (check out Dan's appearance on my radio show), the Director of Behavioral Finance and Investments at Betterment, who explained that traditional economists believe that incentives, along with logical thought processes, will ultimately dominate our decisions. Behavioral economists “acknowledge that human beings are not always rational and want to help people make better decisions by using their emotions to their advantage.”

As an example, he cited retirement plan enrollment. Since the inception of defined contribution plans, traditional economists thought that the incentive of tax relief to retirement plan participants would be enough to encourage them to start saving money for the future. All they would have to do to enroll in a plan was to check a box. Easy, right?

But that’s not what happened. Many workers simply went along with the default option of not enrolling. To help boost participation, behavioral economists lobbied to change the default to be automatic enrollment and if workers wanted out of the plan, they would have to proactively check the box. Egan says that subtle change helped retirement plan participation soar “from about 20 percent of eligible employees to over 80 percent!”

Behavioral economists want to make it easier for us to do virtuous things, like saving for retirement and harder to do harmful things. Egan contends, “Doing the right thing should be effortless,” and even the small act of checking a box requires a bit of effort.

Another problem inherent with retirement saving is myopia, or our tendency to focus on the near-term, rather than the long term. When confronted with the choice of doing something fun today, like going on vacation with your family or using available funds to help secure a comfortable retirement decades in the future, guess which one tends to win out? Egan calls this the “tyranny of the here and now. To combat it, people need to identify with their future selves and to really think about what kind of life they hope to be leading years from now.”

When it comes to managing our money, being a human being can be downright dangerous. We suffer from two biases when markets are rising: overconfidence in our own abilities to pick winners and optimism, which convinces many investors that they can outperform the market.

Conversely, when markets are diving, we suffer from loss aversion (My dad used to refer to this as the investor line in the sand: “If my portfolio goes below X, I’m getting out!”), which can prompt us to withdraw capital at the worst possible time. When everyone else is selling, there is also a herding effect, when we do what everyone else does. And of course, many investors micromanage their portfolios, when according to Dan, “you will make more money the less you muck around with your accounts.”

All of these behaviors help explain why average stock investors lag the S&P 500 index by 1-3 percent annually and active traders often lag by more than 4 percent annually. Companies like Betterment are using behavioral science to help people overcome their very natures by automating the process of saving and investing. Maybe with a little prodding, we can improve our results.

#270 Stop Being a Lousy Investor


We are wired to be lousy investors, says guest Dan Egan, the Director of Behavioral Finance and Investments at Betterment. Dan explained that the very cognitive behaviors that distinguish human beings from other forms of life, can lead us astray. Unlike traditional economists, who believe that incentives, along with logical thought processes, will ultimately dominate our decisions, behavioral economists acknowledge that human beings are not always rational and want to help people make better decisions by using their emotions to their advantage.

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Behavioral economists want to make it easier for us to do virtuous things, like saving for retirement and harder to do harmful things, like blowing our paychecks on fleeting, short-term pleasures.And if you ever wondered why it's so hard to stay on your diet, go to the gym or adhere to a financial plan, it is because willpower is actually a deplete-able resource - and making virtuous decisions can actually cause fatigue. The answer is to automate as much as possible. “Doing the right thing should be effortless,” says Egan, which is why Betterment uses behavioral science concepts to help people overcome their very natures.

Thanks to everyone who participated this week, especially Mark, the Best Producer/Music Curator in the World. Here's how to contact us:

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Financial Nudging Works!


Having a hard time saving for retirement? You aren’t alone. The problem is that unless we automate the process, saving often becomes an afterthought. And who can blame you? It’s way more fun to go out to dinner, take trips and buy tech toys then to stash that money into a long term saving or investing vehicle. But what if you never got a chance to get your hands on the dough – would you miss it? Many retirement plan sponsors are testing this theory in practice. The trend started with the passage of the Pension Protection Act of 2006 (PPA). In addition to addressing issues around defined benefit or pension plans, the law also contained big changes for employer-sponsored retirement plans.

After years of low enrollment levels (according to the Employee Benefit Research Institute, roughly 30 percent of workers who had been offered a 401(k) plan at work failed to participate in it, and many workers made no change to their contribution rate or investment choices once they did sign up), retirement experts along with academics who study behavioral finance (the intersection of psychology, sociology, business and economics), petitioned the government to help nudge employees into better financial behavior.

In the PPA, the Department of Labor blessed the automatic enrollment of workers into defined contribution retirement plans at a default savings contribution rate (usually 3 percent); default investment elections into age-appropriate “life-cycle” or “target date” funds; and automatic escalation of workers' contributions to their 401(k) accounts on a periodic basis.

Of course employees could always opt out of a retirement plan, elect a different contribution rate, or choose different investments, but to do so would require taking action. And given human nature, you can guess what happened: more employees have participated in retirement plans and the shift also helped workers form the retirement savings habit early in their careers, a critical step to staying on course to hit financial goals, according to behavioral economists.

According to the Bureau of Labor Statistics, one study found a whopping 48-percentage point increase in participation among newly hired employees and the BLS itself found that plans with automatic enrollment have participation rate that is 8.4 percent higher than do plans without the feature. “Automatic enrollment has been particularly successful at increasing 401(k) participation among employees least likely to participate in retirement savings plans—namely, employees who are young, lower paid, black, or Hispanic.”

In fact, as much as we hate it in the moment, most of us respond pretty well to gentle nudging. Last year, American Century Investments conducted a survey of soon-to-be retirees and found that they would have liked their employers to play a more active role in helping to save for retirement. Maybe this kind of thinking only comes with hindsight, but when asked exactly what they wanted their companies to do, two in five said “a slight nudge,” while an additional two in five preferred either “a strong nudge” or a “kick in the pants.”

Some employers have responded with something in between a gentle nudge and a kick in the pants. A small group of companies are carrying behavioral finance to the next level by auto enrolling participants at an 8 or even 10 percent level. They report that the employee response has been pretty much what you might expect: they accept it.

The beauty of any automatic saving or investing plan is that it takes the onus off of you to do something and maybe even alleviates that low level of guilt that might be kicking around your head that you should be doing more. In fact, whenever possible, consumers seem to reap the benefit of financial nudging, whether in retirement contributions, automatic rebalancing of investment accounts or automatic bill paying. Whenever we can extract the emotional pull of inertia from the process, we are likely to be better off.