Over the last number of years, I have become very interested in learning more about how human behavior impacts the decisions we make, and in particular the financial decisions that we make. The world of behavioral finance is something that was first presented to me back early on in my career at a former firm, and my interest was rekindled when one of our advisors, Brandt Butt, became interested in it as well.
When you embark on this path you become aware of so many common human behaviors that can have profound impacts on the financial success of a family. One such phenomenon which I was reading about recently is one of the most common errors that investors can make. The bias of round numbers. I recently came across an article from the 'Behavioral Scientist' website called "Why Five and Not Eight? How Round Number Bias Can reduce your Nest Egg" by Ziga Vizintin (Click here to read).
I found the article intriguing because I have had so many conversations with clients where they spoke to me about their savings plan and how they chose a percentage of income as their savings goal, generally 5 or 10%. The article goes on to provide an example, where a recent college grad has to make a decision about how much of their initial income they are going to contribute to their retirement plan at their new job. The individual in the example goes on to say "5 percent seems like a good number; not too much and not too little."
Fast forward 40 years and assume that the individual contributed 5% of his salary of $3,000 per month, the employer matches that amount and the retirement plan earns an average annual return of 5%. After 40 years of work our individual would have amassed $458,000. Not bad. Most would say that this individual has done quite well. But what if instead of choosing a round number, this individual chose to contribute 8% of their income instead of 5%? In this situation we are talking about a difference of $90 per month. Using the same assumptions, the individual would have saved $732,000 by the time they retire, or almost 62% more.
I think it is stating the obvious to say that if you save more you will have more money down the road for your retirement, so I won't beat a dead horse. The point I am making is that we tend to choose round numbers when we are making financial decisions that could have profound impacts on our future. Let's face it, with a lack of evidence to do anything differently we simply gravitate towards a round number because doing something is better than doing nothing.
If the individual knew that they needed to save 8% to accomplish their goals they likely would have chosen 8% as their savings rate. By not knowing, as is the case for most investors, we choose nice round numbers that make us feel good about ourselves at the time. We also see this bias in dollar values as well with most automatic contributions coming in as round numbers, generally in multiples of $50.
Now given that this bias is built into our human nature, what can we do to ensure it doesn't hold you back? There are two things really.
First, the best thing anyone can do is have a financial plan which identifies the family index rate (rate of return needed to accomplish your goals) along with the savings rate required to accomplish your goals. Knowing how much you need to save on a regular basis will give you the power to make an educated decision or at the very least know that you are not able to achieve your stretch goal. Now I get that knowing what your long term financial goals are is not an easy question to answer, especially if you are just starting out with your savings plan.
The second strategy which can help to eliminate falling victim to the round number bias is having an automatic savings increase built into your plan. What this means is that your monthly savings will automatically increase over time (perhaps a couple of percent per year) as you become more comfortable with your monthly cash flow. By having a plan that automatically adjusts incrementally, it takes the guessing out of your savings rate and adjusts regularly in a manner that is easier to adapt to.
At the end of the day, the key is knowledge. By knowing what you need to do to accomplish your goals you are able to make educated decisions and just like shooting an arrow at a target, minor changes at the beginning can have massive impacts on the results.
- Grant White, CIM, CFP
Grant White is an award-winning Portfolio Manager/Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Grant White who is a Portfolio Manager for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Portfolio Manager can open accounts only in the provinces in which they are registered.
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