Behavioral finance biases show we are more vulnerable than we think when it comes to making financial decisions. The problem is, we’re not usually aware of being manipulated, especially when it comes to decisions about how much to save for retirement or our children’s college education.
People look for clues in the absence of information. This plays out every time we look at a page with a blank field that needs to be filled in—or even at a car with a sticker suggesting the price.
Imagine, for example, that you’re at a car dealership, find a car you like, and see a sign indicating it’s on sale for $12,000, down from a suggested retail price of $15,000. You choose to buy the car, and you feel you’re getting a good deal. Now, would you feel as confident about this purchase if you had paid $12,000 for the car but then saw the sign in the lot had later changed the suggested retail price to $10,000?
Odds are you wouldn’t be as pleased with your purchase. But why? You have paid $12,000 in both scenarios. The difference is that you’re being anchored to different suggested price points. When making financial decisions, we tend to use what is suggested to us as a guiding tool, even though there is no evidence that this is accurate.
Anchoring affects a lot of our financial decisions and especially influences how we save. T. Rowe Price recently ran a study evaluating how individuals select the amount of money they save per month when setting up their accounts—whether a 529, a 401(k), or another type. During the process of registering for the account, applicants see a blank field on the screen prompting them to insert their monthly contribution amount.
In the first experiment, this field was blank. Occasionally, in other parts of the application, $50 was noted as the minimum. In this scenario, only half of people who filled out the form picked anything higher than $50.
In a second test, the same field provided a dollar figure that was higher than $50. In this case, there was a 20-percentage-point increase in the people who chose an amount higher than the minimum. In other words, simply seeing a suggested higher contribution amount was enough to get people to save more.
The same shift occurred in a third test. Here, exactly half of those who’d signed up for a monthly contribution had committed to the suggested minimum of $100 a month. When “$300” was preentered in the field, the percentage of people saving at the minimum dropped to 25%. All of this illustrates the dramatic impact suggested numbers have on saving decisions.
So, what can you do? Be wary of the effect that lower anchors have on your choices. Do your research, recognize the anchor minimums provide, and save more if that’s really what you want to do.
Another example of a behavioral finance bias that affects our financial lives is the default bias. Let me explain with a personal example.
My wife and I recently bought an oven for our house, and the salesperson pitched us a warranty. I thought it would be structured so that I would have 30 days to purchase the warranty after buying the oven, but that wasn’t the case. Instead, I needed to purchase the plan on the spot—but had 30 days to cancel it.
Companies know that when we’re settled into our daily routines, and they ask us to take an action outside of that, we most likely won’t. In this case of what would happen if I took no action (the definition of a “default”), they get the sale.
When it comes to retirement, being aware of default bias is incredibly important, especially in the 401(k) world. When starting a new job and setting up a 401(k), it’s imperative to be cognizant of the default contribution and understand if it matches your retirement goals.
For a reasonably comfortable retirement, individuals need to contribute about 15% annually. It’s quite possible your employer has automatically defaulted you into a contribution rate of 3%. Many might think, “Well, my employer has obviously thought about this, and if they think 3% is the right number, why would I change it?”
If the default is lower than 15%, and you take no action to bring it to the proper percentage, will you be set for retirement? You need to ask yourself, “If I do nothing, will this default work for me?” This is a critical step, as the ramifications of not taking an action here can be life changing over the long term.
In other words, don’t let these behavioral finance biases allow you to fool yourself. Look out for the way you may hang onto clues in the absence of information and be conscious of the consequences of not taking an action. Information and awareness are your best friends when it comes to behavioral finance biases; make sure you’re using them to your advantage.
