4 Brain Hacks for Better Investment Decisions
When it comes to investing, we all know what we should do: invest money early in our careers, so compound interest can do its magic; buy low and sell high; and avoid anything that sounds too good to be true. (See also: 4 Quick Ways to Decide if a Company Is Worth Your Investment)
Unfortunately, just because we know what we should be doing doesn't mean we're any good at doing it. Our own cognitive biases and behavioral quirks get in the way of making the best investment decisions, which can really cost us in the long run. We may strive to be completely rational investors, but we tend to act more like emotion-driven gamblers.
However, it doesn't have to be this way. Just because your brain tends to default to emotional decisions doesn't mean you're stuck with them. You can trick yourself into making better investment choices — without having to fight your nature. Here are four brain hacks you can implement today to improve your investing.
1. Imagine Yourself With Wrinkles and Liver Spots
The very biggest investment mistake that most people make is failing to invest at all. Even when your employer makes it relatively easy to invest in a 401(k), it's even easier to do nothing — or only invest the bare minimum. That's because your future self feels like a stranger to you, so it's difficult for you to care about him/her. (See also: 6 Valid Reasons Not to Contribute to Your 401(k))
I recall a coworker who once told me with a straight face that she didn't bother saving for retirement because she wanted to enjoy her money now. This woman simply didn't care about the cat food-eating retiree that she would become because that future self didn't feel real to her.
This is a phenomenon called hyperbolic discounting.
Human beings tend to place much more importance on things that happen now, and discount anything that might happen in the future. It's why it's so difficult to bypass that chocolate donut in the morning meeting, even though you're trying to slim down for a wedding or reunion next month. Your immediate gratification seems to be so much more important than your future trouble fitting into your dress.
When it comes to retirement, many people feel like my former co-worker. They may feel like they really need the money now. Why bother putting it aside for some future self — who feels like a stranger?
Meet Your Future Self
The solution, according Hal Hershfield of New York University's Stern School of Business, is to get acquainted with your future self.
Specifically, Hershfield found that participants who looked at age-progressed pictures of themselves increased their saving behavior. Suddenly, seeing a be-jowled, wrinkled, and white-haired version of themselves made it clear to reluctant investors that they actually would reach retirement age — and boy would that extra savings come in handy.
Basically, when you see a representation of what you will look like in 40 years, it makes your future self's financial concerns much more immediate.
You can create an age-progressed picture of yourself for free at www.ageme.com.
Wise Bread readers already know that they need to automate their savings and investing. It's the best way to pay yourself first, because relying on willpower is simply not going to cut it. Willpower is like a muscle, and it can be used up — even with unrelated issues. Anyone who has ever gone on a shopping spree to celebrate losing a few pounds, or who has gone face-first into a bag of cookies after successfully avoiding spending temptations, has felt the weakness of willpower.
But even if you automate your savings and investing, you can do more automation in order to periodically increase the amount you put aside. For instance, if you know you can count on a 3% raise each year, it can be easy to let that money simply add to your lifestyle creep. A month prior to when your raise will kick in, let your rational side take the temptation to spend your extra cash out of the equation. Arrange for your 401(k) or other investment contribution to go up by 1% to 2% before you've even seen the check with the additional money it. That will allow you to ignore the emotional temptation to spend now. (See also: Lifestyle Inflation: The Ultimate Financial Trap)
3. Set Short-Term Goals
I have a dirty little secret. Despite the fact that I am the daughter of a financial planner and a personal finance writer, I have often put money aside for my son's college education ahead of saving for my retirement.
I certainly know better — but saving for my little one's education is a goal I can easily wrap my head around, and one that has a specific end-date and dollar goal. Putting money away for college feels like I'm doing something tangible that is working towards an achievable goal. Putting money away for retirement feels much more amorphous.
My problem is a common one, even among diligent savers. It's difficult to really comprehend the huge investment goal that is planning for retirement, but a more tangible goal like saving for college or a vacation is much easier to grasp. This is related to hyperbolic discounting, since we are able to give up our need for instant gratification if we can feel like we're making progress on a short-term goal. (See also: Managing Your Short-Term Money)
In order to keep yourself from letting those short-term goals get in the way of your long-term ones, behavioral economist George Loewenstein recommends that investors "set short-term goals designed to accomplish long-term goals." This strategy will allow you to take care of your future needs, while still giving you the short-term gratification you need to stay the course.
For me, since retirement is such a huge and undefined goal, I need to set immediate goals for my money within the big goal of retirement. For instance, my current short-term retirement goal is to max out my IRA contribution every year. Once I am able to do that, I will add a new goal of maxing out my Self-Employed 401(k), which has a much higher contribution limit. These goals are actionable, tangible, and allow me to feel a sense of accomplishment, whereas just planning to "save more for retirement" is none of those things.
4. Hide Your Statements From Yourself
It truly hurts to lose money. I can tell you the exact amount of money I have spent on various unused purchases that ended up being nothing more than clutter — because it hurts so much to think about the money I wasted.
This universal phenomenon is called loss aversion, and it's the reason why you're still using that treadmill in your basement as a place to hang laundry, and the reason why you might have sold a bunch of faltering stocks in the economic recession only to see them rebound. In the first instance, you hate the thought of taking a loss on selling off the treadmill, even though the money you can get through a sale is more than you have currently. And in the second, you can't stand the thought of losing any more money when things are not going well.
Unfortunately, loss aversion is so hard-wired into our brains that it is very difficult for investors to think rationally while in the midst of a loss. Fear makes investors sell low in order to protect as much of their initial stake as possible. And often, those same investors will not feel confident enough to reinvest until the market has returned to a high point, meaning they have sold low and bought high.
Since you cannot override your emotional reaction to a volatile market, the best solution is to selectively bury your head in the sand. While it is absolutely critical that you keep an eye on your investments and readjust your assets and your strategy as necessary, it is also a complete mistake to react to every movement of the market. So commit to only looking at your investments at pre-determined times.
For me, I find that reviewing my investments quarterly can help me to overcome the panic I might feel at market losses and stay the course for the long term. (This also prevents me from feeling like I can guess what the market is going to do and jumping on "hot" new stocks.) Forcing myself to ignore the short-term ups and downs of my investments will allow me to better understand how they are doing over time.
Your Brain Is Costing You Money
We now know that there is no such thing as a completely rational investor. We are all slaves to our emotional/irrational brains, which will lead us into a much poorer future than we really want. The most rational investors are the ones who have found ways to circumvent their own irrationalities.
Brain hacks like these can help your to protect yourself from your own worst impulses.
What are your favorite investment brain hacks?