We all have important financial goals we want to achieve – such as saving for retirement or leaving legacy gifts. But did you know that there are five cognitive processes hardwired into our brains that can sabotage our ability to achieve our goals?
These five mental roadblocks, so to speak, are well-known for their ability to impact our perceptions and actions. As such, they hold the potential to turn our brains into our worst enemies in making wise financial decisions. Let’s examine them and how to overcome them.
In physics, the principle of inertia states that a body in motion tends to remain in motion, while a body at rest tends to remain at rest. In our financial lives, inertia – our tendency to maintain the status quo – is ever-present.
How many times have you seen people continually put off doing things that they know they need to do, such as buying life insurance? Conversely, how many times have you seen people continually do things that they know they shouldn’t do, such as overspending on credit? Both of these are examples of how inertia can work against us.
Inertia can work in our favor if we’re on a path that is advancing our financial goals because we tend to stay on that path. But if our actions are undermining our goals, inertia makes it difficult to switch gears.
Anchoring refers to our tendency to fixate on certain pieces of information in our decision making. Say you’re out shopping with your teenage daughter, and she finds designer jeans for 25% off their regular price of $200. She feels she’s found a bargain because the $200 price tag is the anchor she has latched onto in valuing the jeans. But if the last pair of jeans you bought cost $50, you may have a different anchor. What’s the “right” price for designer jeans or anything else? It depends on your anchor.
Applying this to finance, it’s well known that when people suffer financial setbacks, they often find it difficult to downsize their lifestyles because they’ve anchored to a higher standard of living. Similarly, few people are willing to sell their home for less than what they paid for it – even if market conditions warrant it – because their purchase price is their anchor.
No one likes to lose money. In fact, an aversion to asset losses is deeply ingrained in us. We can temper it by developing a clear picture of our risk/reward preferences, and investing accordingly. But even so, this innate fear, if unchecked, can lead to poor investment decisions.
One example of this is the tendency of many investors to move into cash when the markets tank. This is a form of market timing and it is generally a losing strategy because the pattern and timing of recoveries cannot be predicted. Sitting on the sidelines during even part of a recovery can be costly.
Over the 20 years ending in 2014, for example, the S&P 500 earned an average annual return of 9.8%. But if you missed participating in the market’s 20 best days during those two decades, the return dropped to 3.6%. And if you missed the 40 best days, the return was -0.4%. The S&P 500 Index is unmanaged and cannot be directly invested into. Past performance does not guarantee future results.
Have you ever heard of the marshmallow experiments of the 1970s? In these famous behavioral psychology experiments, young kids were put in a room with a marshmallow and were told that if they could hold off on eating it for just 10 minutes, they would get a second one as a reward. The test subjects were followed over time, and researchers found that those children who abstained from eating the marshmallow tended to go on to achieve more academic success and earn more money in their careers.
All of us, young and old, have a natural tendency to value immediate rewards over longer-term ones – to eat the marshmallow now. But if we succumb to the temptation to “let the future take care of itself,” we can harm ourselves by failing to plant the seeds for our future wellbeing. Moreover, our present bias can erode the dedication we bring to working towards our financial goals, since goals are, by definition, future-based.
This bias can be a particularly daunting obstacle in retirement planning, the ultimate future-based endeavor. This is no doubt one reason why a large segment of the U.S. population has inadequate retirement savings.
Our brains are renowned for creating blind spots in our thinking – an inability to see certain aspects of ourselves or elements in our environment that can create problems. Blind spots can hinder our ability to create a comprehensive plan for our financial future, as well as our ability to identify the risks that may derail our plans. As such, they may constitute our most challenging cognitive frailty because we just don’t know which pieces of the picture we are missing.
Are we prisoners of our mental roadblocks? Absolutely not! But because these mental processes are an entrenched part of our cognitive selves, they can be tricky adversaries. So we need to consciously make an effort to overcome them.
One way to do this is to make a reality check a routine part of your financial decision making. Each time you approach a significant decision, stop and ask this key question: Does this move me closer to or away from my financial goals?
To help ensure you answer that question honestly, consider working with a financial advisor on an ongoing basis. A good advisor is a valuable ally who can help you avoid the pitfalls of your mental roadblocks, and can draw up a customized financial plan that can put you – and keep you – on the path to achieving your true goals. So have a serious talk with your brain about bringing on a financial advisor who can help both of you get to where you really want to go.
– Diane “Skye” Gropper is a Financial Advisor with Waddell & Reed and can be reached at 623-334-4726. Founded in 1937, Waddell & Reed is among the most enduring asset management and financial planning firms in the nation, providing proven investment and planning services to individuals and institutional investors. Waddell & Reed, Inc. Member SIPC (01/16)