Published November 5, 2018|3 min read
Saving money is hard. Making enough income to set aside comfortably is a big enough hurdle, but our psychology may also get in the way.
Researchers have identified a number of ways psychology keeps us from saving more money. Learn what these cognitive biases are and how to overcome them.
Present bias is basically procrastination. It means you tend to favor immediate rewards over far-off benefits.
"The present carries more weight relative to tomorrow," said Paolina Medina, assistant professor of finance at Texas A&M.
Someone who doesn't suffer from present bias will make a plan to save money when they get paid on the 15th, and when payday comes, they'll put that money away. Someone who suffers from present bias is more likely to waver as payday approaches and keep putting off the decision to save.
Present bias has a powerful impact on retirement savings because retirement is far in the future. This tendency to procrastinate affects whether and how much you save. (Here are seven ways to overcome money procrastination.)
Limited memory is a similar bias. Most people know they will likely have future expenses like health emergencies. But not everyone keeps those future expenses top of mind, Medina said.
"When you are thinking about going to the movies or going to a restaurant, you are not thinking you may face an emergency in the future and you need to have funds available for that emergency," she said.
We know it's inevitable that we will experience some sort of financial emergency down the line, whether it's a hospital stay, a car breaking down or a natural disaster, but when we're at the movies, we don't think that buying a ticket makes us less prepared. We just think of the movie, because there are limits on what we can worry about.
Exponential growth bias is a scientific way of saying that people really don't understand compound interest. People undervalue how much compound interest allows their money to grow over time, said Gopi Shah Goda, senior fellow and deputy director at the Stanford Institute for Economic Policy Research.
This causes people to spend more than they save because they discount the long-term rewards of saving. Goda co-authored a paper studying how biases affect retirement saving. It found people with a stronger exponential growth bias ended up with lower wealth at retirement age.
Goda is studying how to counteract present bias and exponential growth bias. One way to beat exponential growth bias might be to use a retirement calculator that shows how compound interest accelerates the growth of your retirement savings. You may not understand the underlying math, but you can see how investing more earlier makes the numbers bigger. A calculator could also show someone the downside of putting off retirement contributions.
The Securities Exchange Commission has a compound interest calculator, as do many personal finance websites.
Another way to overcome your brain is to take savings decisions out of your hands. You can beat present bias by setting up automatic deposits from your paycheck into a savings account, Medina said.
She compared this to a story from the Odyssey, when Odysseus wanted to avoid hearing the Sirens, whose song lured sailors to death. He ordered his men to tie him to the mast and plug his ears. Setting up automatic deposits "ties your hands" in a similar way.
The envelope system, in which you set monthly limits for spending in various categories like dining, entertainment, groceries and savings may also prevent you from shirking savings because you set aside money for spending ahead of time.
"We're going to feel that the money we set aside for savings can not be used for anything else," Medina said.
By getting ahead of your tendency to spend and by taking savings decisions out of your hands, you can beat your brain's biases against saving.
For more tips, here are five easy ways to start saving in five minutes or less.
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