This is a guest post from Michael S. Potapov, CFA. Michael has worked at E.S. Barr & Company since May 2006 and is responsible for researching individual holdings as well as assisting in portfolio management. Before joining E. S. Barr & Co., Michael worked as a financial advisor with Dupree Financial Group creating and maintaining asset allocation models as well as identifying investment opportunities for individual investors. Michael is a magna cum laude graduate of Georgetown College with a B. A. in Commerce, Language and Culture program, as well as Music. He received his CFA charter in 2008 and is a member of the CFA Society of Louisville, KY and the CFA Institute. Michael serves as Treasurer on the Board of the Bluegrass Conservancy.
Financial planning for retirement appears straightforward in theory. However, many people discover that sticking to a plan may be quite challenging in practice. Everyone knows about the virtues of beginning to save early since compounding over time is such a powerful idea. Still, many fail to save anything, often despite having a good income. Below are a few ideas on how to bridge the gap of saving in theory and saving in practice:
Saving $1,200 per year ($100 per month) and investing the money at a 10% return will turn about $55,000 in total contributions into $1,000,000+ over 46 years. Assuming a sustainable withdrawal rate of around 5%, one million would generate about $50,000 in income in retirement.
Who wouldn’t want to make 20 times their initial investment and build a base for steady income in old age? Saving a few hundred dollars per month does not seem like it would be such a burden. If we just follow a plan, it will all work out because it is all logical and perfect…
In reality, things often turn out a bit more complicated. According to the 2013 Federal Reserve survey, some “45% of respondents reported that they did not save any portion of their income in 2012.” Only about a third of respondents age 18-44 had savings to cover three months of expenses and almost half of respondents gave just “a little” or no thought at all to financial planning for retirement.
Understanding the details of the Fed’s survey and its implications is beyond the scope of this article, but many other studies appear to support an assertion that people are finding it difficult to implement the theory. Assuming a person has enough income to satisfy basic necessities and has the flexibility as to whether to spend or to save some or all of the excess, a few ideas from behavioral finance may help bring practice closer to theory.
Humans appear to have difficulty thinking long term. Visualizing and planning for something just a few years from now is hard for most, so a few decades seems nearly impossible. Spending a few hundred dollars that would provide near term satisfaction in a form of a nice meal, an entertainment event, or an item of clothing today is tangible and enjoyable. Putting money away towards some nefarious goal a long time from now seems entirely boring and unsatisfactory in comparison. “Surely, these few hundred dollars today won’t make any difference 20 years from now…and I will feel better now if I have this item I really want!”
Of course, if you are reading this, you are thinking about the long term – you are looking for a hint to make reaching your goal easier. One helpful solution is making savings automatic. Most employee contribution plans (401k, 403b, etc.) allow for automatic deductions from a paycheck. Likewise, many fund companies allow for automatic monthly investment directly from a bank account. Making saving and investing automatic removes the need to force oneself to act, because the easiest thing when it comes to a difficult choice is to do nothing.
Sticking With the Plan
Only in theory do investments steadily grow by 10% every year. In reality, getting to a healthy long-term return requires assumption of different types of risk, one of which is volatility, or the up and down fluctuations of price. Volatility is always uncertain on timing, so the best strategy is just riding it out, which takes a long-term mindset. While the historical stock market returns averaged around the 10% mark, the results in any given month, quarter or year can deviate from the average very materially.
As we already discussed, keeping the long term perspective can be challenging. It may seem helpful to receive and review a monthly statement or have the ability to track the value of an investment account daily online, but an investor is then nudged to focusing on the near term as the comparison to the previous month or day’s end is prominently featured.
To encourage long term focus, consider using the online login feature to your advantage. Go “green” by stopping the hard copy statements and making the login password truly secure – meaning long, complicated, and not easily remembered. Typing the password into a notes app on your phone or using a password manager is convenient, but in this case may be disadvantageous as it will make checking the balance too easy. Go low tech and write the password down on a piece of paper and put the note away in a secure location. This way, any time you’d like to check on your account, it’ll be somewhat of a hassle and you won’t do it very often, bypassing the short-term thinking reinforcement.
If you invest in individual equities, past prices and performance are often the focus. If you bought a stock at $50 and now it trades at $100, you feel you’ve done well. If it now declines to $80, you feel badly because you feel you should have sold at $100. If the decline continues to $70, you might get more anxious, but still decide to hold on until it recovers to at least $95. As the price approaches $50, you may feel that selling is the right thing now since you wouldn’t want to lose what you put in.
The idea of “anchoring” suggests that we make decisions relative to some, often arbitrary, numbers we have been presented with. In the stock example, anchoring to the purchase price or the highest price the stock had reached drives the emotional decision of what we aim to do. When buying a car, you may be presented with the “dealer invoice”. The amount on the invoice may have little relevance to the actual value of the vehicle, but it is very likely to have an impact on how you feel about the price you might actually pay.
Stock prices and dealer’s “best offers” fluctuate significantly without regard to actual value – for stocks, simply because the expectations of future performance change and for cars, because of how excited the buyer may be about the new ride. To illustrate, consider the yearly lows and highs for stocks as published in financial newspapers or available online. For example, in 2014 the low price of Apple stock was $67.77 and the high price was $103.74 – did the value of Apple’s business really change by 50% over the course of twelve months? Probably not, since the value of any business is based on the sum of future earnings for many years discounted to the present.
Thinking about the long-term value of a business can serve as a better anchor for making buy and sell decisions, just as understanding the value of a car from an independent source would result in a better anchor than the “dealer invoice”. Before making a buy or sell decision, take a step back, think about how you arrived at what seems to be a “good” or “fair” price. Was it because some arbitrary number influenced your choice? Or did you do some research to establish the value based on more objective parameters?
Understanding how we make decisions and bypassing the traps our minds can set can help avoid mistakes and make achieving our goals much easier. Often, the path to success is navigated not by making brilliant moves, but by avoiding the obvious potholes and just taking the less curvy road to get there.
Saving and investing automatically, avoiding short-term thinking by making it harder to regularly check your investment balances, and being aware of how “anchoring” may be affecting your judgement are just a few suggestions based on the research from the field of behavioral finance. Working with an experienced, trusted advisor well-versed in these and other ideas may also help you keep on track bringing investment practice closer to theory.
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