I can remember one of the first times I had to make a money decision. I was on vacation with my family and I fell in love with a little summer dress that was in the window of the local surf-clothing store. It was on the last day of our vacation and my mom said that if I wanted it, I had to pay for it myself. I couldn’t part with my money and so I spent the next four hours in the car-ride on the way home, agonizing about this outfit I would never have. Of course, there are always more clothes to buy and I really didn’t need the dress, but the emotion was so powerful, as a young kid I found it hard to ignore.
I’ve experienced this feeling many times since, and I’m sure you’re all too familiar with it. It has an official name: The Gruen Transfer. Scientists have studied the effect, and can determine the split second when a mall’s intentionally confusing layout makes our eyes glaze and our jaws slacken… the moment when we forget what we came for and become impulse buyers.
There’s a science and psychology behind advertising and selling, because underneath every rational, calm exterior is a predictably irrational human mind that, with the right conditions, will fall prey to an impulse buy every time.
The same principle applies to investing. You see that everyone is buying up on a particular stock so you do too â“ but high chances are you’re paying an inflated price. Or you see your stocks go down and so you sell out in a panic. This behavior pattern is buying high and selling low, and it’s the reason many individual investors significantly underperform the funds they invest in.
We know the right approach (get rid of debt, save more than you spend, have an emergency fund, then grow your money through investing), but without a plan in place it’s near impossible to actually achieve this â“ because of our cursed behavioral instincts! Studies by Hershfield, Goldstein, et. al. have shown that we find it hard to picture our future selves â“ preferring to favor short-term or immediate gains, over long-term gains.
Dan Ariely, Professor of Behavioral Economics and Author of Predictably Irrationalâ, says that humans will make predictably irrational decisions. By recognizing the patterns in our natural biases and irrational behaviors, we can make better decisions â“ and beat ourselves at our own behavior game.
I often think of that little summer dress (and every major and minor purchase I’ve walked away from since) when tempted to make an impulse buy. My life is neither better nor worse without those purchases, which is always a timely reminder! If this isn’t possible for you, just don’t go to the mall until you have a need â“ and then, take a list and stick to it.
After mastering the art of avoiding the impulse buy, you might find that you’re still no richer at the end of the month. Or on the flip side, have you ever found that when you desperately need money for an emergency or major purchase you always find a way? It’s because we mentally allocate our money to different things.
If you plan to invest whatever’s leftover you will never get there. Turn on auto-deposit so money leaves your account before you even have time to allocate it somewhere else. This is something we integrate and strongly recommend at Betterment. You don’t need to set aside thousands before you invest, you can set up auto-deposit in your account and that money is immediately invested across a diverse range of stocks and bonds (currently over 3500 companies).
Diversification means exposing your investment to a wide array of stocks and bonds in order to limit risk. It cushions you against volatility because you will own a tiny fraction of many companies in many industries. It means you’ll be less tempted to meddle with your portfolio and make mistakes, because large swings in specific stocks won’t drastically affect your investment.
Betterment’s online tools help you understand what level of risk is right for you. Like diversification, setting the right asset allocation is a measure against risk. It ensures that your money will be there when you need it (while growing it as much as possible in that time). Setting the right asset allocation and investing in a diverse portfolio from the outset means you need to make fewer changes â“ eliminating the potential for behavior-driven mistakes.
Rebalancing is recommended to realign your portfolio back to its original asset allocation after market shifts. It’s a good practice to get into because if the allocation shifts too much over time, you are unintentionally exposing yourself to risk. Trouble is â“ even the most seasoned investor can forget to do this. That’s why we make it an automatic function in all Betterment accounts.
Goal Based Investing
Remember how I said it was difficult to picture your future self? Well, it gets a little easier if you think about what you actually want to achieve in your life. A recent article in the Wall Street Journal recommends thinking about your money in terms of bucketsâ not budgetsâ. It’s not enough to say â“ I want to increase my investment this yearâ â“ you need to make it specific like I want to save $100,000 for a down-payment on a home in 10 yearsâ or I want to save $5,000 for a trip to Romeâ. If you’re starting out, you may want to go with something like I want to invest $2,000 a year for the next five years.â Betterment allows you to set up individual goals tailored to specific type and time frame, which helps you immediately act on your investing plan.
Humans tend to think that we’re above average, on average. It’s statistically impossible for us all to be so good at everything! It’s called over-confidence bias and it’s another behavioral bias that causes us to make poor investing decisions. By being aware of irrational behavior patterns and putting the right measures in place, you can beat your bad behavior and have a healthy investment plan set up in no time. The best thing about a set and forget approach? You can get on with living your life.