Jonathan M. Gardey, MBA, CFA®, CFP®
President and Chief Executive Officer
Why do people struggle to make the right decisions about their money? On a conscious level, we know what we're supposed to do—i.e., saving our money, living within our means, and avoiding debt. But it seems there is a divergence between what we know to be the right thing to do and the actual decisions we make.
That behavioral deviation leads to many people struggling to meet their financial goals. But why does that happen? If we consciously know what we should be doing with our money, what keeps us from doing it?
How Human Nature Risks Our Financial Future
There is a mountain of research on behavioral finance that attempts to account for the poor financial decisions people make. It offers evidence backed by decades of data to show how investors risk their financial future with bad choices.
Take the annual Dalbar study, which tracks investors' performance versus the returns of the S&P 500 index. Its 2021 study found that the 20-year annualized return of the S&P 500 was 7.43% through 2020, while the return of the average equity mutual fund investor during that period was just 5.96%. While that may seem like a small gap, a hypothetical investment of $100,000 invested in the S&P 500 would have grown to $420,000 compared to $318,000 for the average investor. Dalbar attributes that $100,000 difference to emotionally based market timing decisions.
Considering how humans have evolved over thousands of years, it's not surprising to learn that our brains are wired to make the wrong financial decisions. Until very recently (the last hundred years or so), humans were forced to focus on short-term survival amid a world of resource scarcity and constant threat.
Why save for the future if you have no future? In a "live for today" world, you look for instant gratification and hope to live another day. That's a deeply entrenched human experience of survival that has shaped our instincts even to this day. It's not a question of why we make bad financial decisions because that is human nature. The question is, why would anyone make the right decisions, which requires a conscious effort to overcome our deeply ingrained instincts?
1. Humans' Aversion to Loss
One example is "loss aversion." The theory of "myopic loss aversion" says that people are much more fearful of incurring losses in the stock market than they are happy when their investments go up. When the stock market declines sharply, investors' loss aversion instincts take over, forcing them to take whatever measures they can to prevent a loss, including selling in panic—a sure way to hurt long-term investment performance.
2. The Herding Instinct
There's a natural human tendency to fear being left behind or missing out, which can drive people to follow the herd—over a cliff in a crashing market or to flock to stocks near a market top, both of which invariably end badly. The big asset bubbles in history, including the dot com bubble of the late 1990s and the housing bubble in 2008-2009, can be attributed to the powerful "herd instinct."
3. Our Human Nature is Reinforced in Childhood
Most people enter adulthood with very little financial education to prepare them for making sound, long-term-oriented financial decisions. Many rely solely on what they may (or may not) have learned from their parents or by following the examples of their peers. Absent any intervening financial education or coaching, the habits and behaviors we learn as children are self-reinforced, creating a financial persona we carry well into adulthood. In fact, by age 7 many of our money habits are already set.
The propensity for immediate versus delayed gratification is born out of human nature but is bolstered through learned habits and behaviors developed early on. That propensity is first tested with college students who have delayed gratification out of necessity. When they graduate and get their first job, they must choose between continuing to delay gratification by saving a portion of their earnings or chasing a lifestyle that has alluded them. That decision can mean the difference of hundreds of thousands of dollars available to them later in life to pursue their life ambitions.
How the Cost of Waiting Can Cripple Your Financial Future—A Theoretical Case Study
Consider the hypothetical of two college graduates—Linda, who chooses to save now and spend later, and Frank, who decides to spend now and save later.
Linda established a 401(k) through her first employer, at age 25, and began contributing $800 per month to a diversified portfolio of funds generating an average annual return of 6%. Due to a disability, she had to stop contributing to her retirement account at age 45, by which time she had accumulated just over $360,000.
Frank decided he had time to get serious about saving for retirement, choosing instead to pursue the lifestyle he wanted. He waited until age 45 to start saving, about the same time Linda stopped contributing to her plan. Even though he was making a lot more money at the time, his lifestyle habits only allowed him to contribute $800 to his plan. He also invested in a diversified portfolio of funds with an average annual return of 6%. So, by the time he turned 65, his account had grown to just over $360,000.
Meanwhile, even without additional contributions, Linda's account continued to compound its earnings, growing to nearly $1.2 million by the time she turned 65. Frank's cost of waiting to save was over $800,000.00!
For Financial Success, You Must Break the Bonds of Human Nature
Undoubtedly, the forces of human nature and the instincts wired in our brains are powerful, creating a behavioral default that, without any outside intervention, can lead to costly money management mistakes. Outside intervention, such as financial education or a financial coach (i.e., a financial advisor), is the only way to overpower natural impulses and avoid the costly behavioral mistakes that can sink your financial future.
If you are in need of a guide who can help you overcome some these hurdles, we encourage you to schedule a call. Having a mentor and guide can make all the difference in your ability to save and protect your wealth for the future. We best serve clients looking for exceptional client service, who value a long-term partnership, and have a minimum of $500,000 in investable assets.
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