Saving for retirement is a challenge facing most Americans. Research shows the challenge is made harder by our basic human impulses. We know we should be saving. But we don't. We consistently make bad financial decisions.
One thing that leads us astray is what behavioral economists call "loss aversion." In other words, we hate losing. And that gets in the way of us winning — if winning is making smart financial decisions.
How A Smashed Car Is Like A Smashed Nest Egg
A few months ago I got rear-ended and my Jeep Cherokee was totaled. It's the first new car I ever bought. (That was 15 years ago, so it wasn't new anymore.) But I loved that car. And I hated losing it.
Insurance didn't give me much money to replace it. But still, I ran out with that $3,000 and impulsively bought the first cheap car that looked like my old one to replace it. The problem is, the underside of it was really rusty. I should have known the car would be more trouble than it was worth.
But it was like my primitive brain took over. I just wanted my car back. And I bought it anyway. Fast-forward three months, and three other things have broken on the car. It won't start. And I've discovered "frame rot." Ken Lucas, the owner of Elite Bodyworks in Boston, took a look at the car and said the rust is "extremely bad." He adds, "I wouldn't recommend you drive it."
I cover financial stuff as a reporter and I've always saved a lot for retirement. So why did I make this rash decision to buy such a clunker?
Well, it turns out a lot of Americans make all kinds of bad financial decisions for exactly the same reason.
We Hate Losing More Than We Love Winning
Professor Brigitte Madrian teaches behavioral economics at Harvard. "You experienced this loss of your car, and you wanted to make the loss go away," she says.
Madrian says this human instinct to avoid loss — she calls it "loss aversion" — is very powerful. In fact, once we have something, we hate losing it more than we enjoyed getting it in the first place. "It hurts twice as bad," she says. "The literature suggests that people are twice as sensitive to losses as they are to gains."
In other words, we hate losing twice as much as we love winning. And that gets us into trouble with financial decisions because it gives us the wrong impulses. These can lead us to make bad choices, involving a lot more money than a cheap, rusty car.
The Mistake Of Buying High And Selling Low
Generally, people understand that to make money investing in the stock market you want to buy low and sell high. But our instincts can lead us in the other direction. Take the stock market crash in 2008. A lot of people felt that loss so intensely, they did what they should never do: They sold all their stock after the market had already crashed and lost half its value.
Madrian says the sense of loss is very powerful in a situation like that. And they wanted to act, to stop the bleeding, to make the pain go away. So people lose sight of the more rational idea that if you are in the market for the long haul, if history is any guide, the market has always recovered.
So why sell after stocks crash? It's a human, emotional decision. Not a considered, analytical one.
Saving Isn't Losing, But It Feels Like It
People know they should save. But most of us still just don't like writing a check to squirrel money away for the future. Madrian says that feels like a loss from our checking account. And our aversion to that is very strong and it often irrationally wins out. So, Madrian says, the best advice by far is to take advantage of things like an automatic payroll deduction.
In other words, getting your employer to put part of your pay into a retirement account before it ever shows up in your checking account. That sort of tricks us into feeling like we never had the money in the first place. And that saves us from ourselves. "The money you don't see is the money you don't miss," Madrian says.
Something We Should Fear: Fees
Usually, mutual funds and financial advisers don't ask you to write a check to pay them. They just take a percentage out of the money they're holding and investing for you. But that's often very expensive over time. People agree to it, though, because the cost — and the loss — isn't as visible. In this case, Madrian says, "the loss you don't see is the loss you don't feel."
She says if you find a good financial adviser, you'd be better off paying him or her by the hour to sit down once a year to give you advice — the same way you pay someone to do your taxes. Paying 1 or 2 percent of your entire life savings every year in fees could potentially cost you hundreds of thousands of dollars in lost profits over the course of 30 years.
So keep an eye on those fees. Many retirement experts recommend diversifying investments across a broad range of stocks, bonds, real estate investment trusts, and international stocks. Index funds and exchange-traded funds, known as ETFs, often have fees that are much lower than "actively managed" mutual funds. And the experts say a mountain of research shows you are much more likely to make more money over time if you invest in these lower-fee funds.
Keep Your Head
Madrian says with all important financial decisions, it's good to take your time. Seek out good advice, and don't overpay for it.
As for me, my Jeep still won't start. And I'm trying to get the guy who sold it to me to buy it back. Wish me luck.
ROBERT SIEGEL, HOST:
From NPR News, this is ALL THINGS CONSIDERED. I'm Robert Siegel. Saving for retirement is a challenge most Americans face and research shows that challenge is complicated by basic human impulses. We know we should be saving, but we don't. We consistently make bad financial decisions. NPR's Chris Arnold reports on how emotions get in the way.
CHRIS ARNOLD, BYLINE: To understand one reason why we have such a hard time saving for retirement, I'm going to tell you a story. It's a story about my new car. Actually, it's a story about my old horrible car, but I just bought it three months ago. OK. So I'm getting into my new old Jeep here and I'm going to go see my mechanic or my body shop guy.
OK. Here's what happened. I had this old Jeep Cherokee. It was the first new car I ever bought back 15 years ago. I loved that car. But then, this jerk rear-ended me when I was stopped at a traffic light and the car got completely totaled. Insurance only gave me $3,000, but still, impulsively, I ran out with that money and bought the first car that I could find that looked like my old one to replace it.
The problem is what I got for that was a beat-up, cheap, old rusty used Jeep and now, I am, as you might imagine, having some regrets. So I can't believe this car is as rusted out as it is. And listen to that rattle. I mean, what is that? This car is like a loose, rusty, bag of bolts.
I take the car over to Elite Bodyworks in Boston. The owner, a guy named Ken Lucas, unfortunately agrees with me. How bad is the rust under the back end?
KEN LUCAS: It's extremely bad. It's probably not a very safe vehicle to drive. And I wouldn't recommend you drive it.
ARNOLD: Now, I cover financial stuff as a reporter and I've always saved a lot for retirement. But when I lost this car that I loved, it's like my primitive brain just took over. And it turns out the reason I probably made such a rash and bad decision is a reason lots of Americans make all kinds of bad financial decisions constantly.
BRIGITTE MADRIAN: You were trying to eliminate the loss.
ARNOLD: Professor Brigitte Madrian teaches behavioral economics at Harvard.
MADRIAN: You know, you experienced this loss of your car, and you wanted to make the loss go away.
ARNOLD: And it turns out, this human instinct to avoid loss, Madrian calls it loss aversion, it's very powerful. In fact, once we have something, like my Jeep, we hate losing it even more than we enjoyed getting it in the first place.
MADRIAN: It hurts twice as bad. The literature suggests that people are twice as sensitive to losses as they are to gains.
ARNOLD: Which brings us back to retirement. We know we should save, but most people hate writing a check to squirrel money away for the future. That feels like a loss from our checking account. So...
MADRIAN: The best advice by far is to take advantage of things like payroll deduction.
ARNOLD: That is, having your employer put part of your pay into a retirement account before it ever shows up in your checking account. That sort of tricks you into feeling like you never had the money in the first place. And that saves us from ourselves.
MADRIAN: The money you don't see is the money you don't miss.
ARNOLD: But the financial services industry has figured this out, too. Mutual funds and advisors, they say, hey, forget it. Don't write us a check or anything. We'll just take a percentage out of the money we're holding and investing for you. That's often very expensive over time. But people agree to it.
MADRIAN: The loss you don't see is the loss you don't feel. You know, if the return on your investment is 8 percent this year instead of 10 percent this year, you might feel perfectly happy because the investment still went up.
ARNOLD: But Madrian says, over time, if you're paying 1 or 2 percent in fees that come out of your retirement account each year over, say, 30 years, that's going to...
MADRIAN: Going to add up to a substantial reduction in what you could've saved over time.
ARNOLD: You're losing hundreds of thousands of dollars.
MADRIAN: Yeah, potentially.
ARNOLD: As for me, my Jeep will no longer start and I'm trying to get the guy who sold it to me to buy it back. Chris Arnold, NPR News, Boston. Transcript provided by NPR, Copyright NPR.