I consistently remind my kids when I sense laziness in their routines of Sir Isaac Newton’s first law of motion. It states that an object at rest tends to stay at rest…so move it!
Now, that’s equally true of falling apples and human nature, and it’s part of the magnificent work done by this year’s Nobel Prize for Economics winner. Richard Thaler has literally changed economics. I want to share some of his lessons with you this week in the hopes that maybe we can adapt his work to help us make more sound financial decisions.
Richard Thaler won the Nobel Prize in Economics for his pioneering work in an academic field called behavioral economics. Most economic theory before Thaler assumed – incorrectly – that people rationally behave when it comes to money, guess what…we don’t. And while we’re sometimes irrational about money, one thing is for certain…we are predictable.
Richard Thaler injects some common sense about human behavior into economic theory. Thaler understands that while rational money planning might work for mythical creatures he calls Econs, the rest of us (including, undoubtedly, some economists) procrastinate and make bad decisions — particular problems when it comes to saving for retirement.
Thaler says employers should “nudge” people in the right direction to make sound investment strategies, but that doesn’t mean you have to wait for your employer to change retirement savings options to benefit from his ideas. Figuring out our own irrational but predictable behavior when it comes to money is key to financial independence and security.
A bird in the hand is worth two in the bush, so the old proverb goes. Folks, that governs our behavior when it comes to assessing short-term risk — a fundamental idea championed by Thaler called “hyperbolic discounting.” Given a choice between getting a smaller reward now or a bigger reward later, most of us will choose the former. This figures in our retirement savings too. We not only disregard the benefit of waiting to cash in, but the further it is in the future, the more we ignore it.
Taking the long view is a sound investment strategy, and it’s also why you should start saving as much as you can as soon as you’re able. To that end, Thaler offers a clever behavioral trick: Time increases to your retirement savings contributions proportional to pay increases at work. That way you won’t subjectively feel a loss in pay because you won’t see your net income decrease.
It’s football season, and some of Thaler’s research had to do with that, too. Specifically, how scouts and general managers in the National Football League overestimated their ability to forecasting which draft picks would be the next superstars.
What I found fascinating was why: partly because scouts and GMs are awash with too much information. In these days of analytics and endless data reporting, you get overconfident about your ability to predict future success based on experience.
Similarly, investors can too often rely on previous corporate performance as a reflection of expected future growth. That fallacy causes investors naïve and shrewd alike to get burned by buying high and selling low.
We don’t know what the future brings, we all get that. But this is why it is so it’s vitally important that any investment strategy manages downside risk as much as possible while minimizing losses. You cannot afford to take significant hits to your investment plan as so many did in years such as ’01, ’02, and ’08. As I teach my clients and I have taught Cutter Family Finance readers for over four years now, if you manage the downside, the upside will take care of itself.
And a sound investment plan must roll into a predictable income plan. Thaler also suggests that those of us in good health wait to claim Social Security benefits as long as possible. “Waiting is the cheapest way to buy more annuity coverage,” he said
The fact is that very few of us wait. About 46 percent of participants begin claiming at 62, and less than 5 percent wait until after age 66. Here’s the thing: The Social Security Administration defines Full Retirement Age (FRA) as 66-67, depending on your year of birth. (1943-1954 it’s 66, 1955-1959 it’s between 66 and 66 and ten months, and 1960 or later, it’s 67).
If you collect Social Security payments before you reach your FRA, benefits can be reduced by 20-30 percent. Think of it this way: waiting can earn you a 7-8 percent increase every year. That’s a nice raise!
Of course, your situation may vary. I get it. But waiting as long as possible to collect Social Security benefits will work to your advantage.
Whether you take the work of Thaler seriously or not, make sure rules, not emotions, guide your retirement and investment goals and expectations. That means not succumbing to irrational behavior. Being mindful of your irrational tendencies can help you manage your downside risk.
Thaler joked that he planned to spend his $1.1 million prize purse from the Nobel committee “as irrationally as possible.” What would you do with an unexpected million bucks?
Be vigilant and stay alert, because you deserve more.
Jeff Cutter, CPA, PFS is President at Cutter Financial Group, LLC, with offices is Falmouth, Plymouth, and Mansfield. Cutter Financial Group provides private wealth and investment management advice incorporating low risk, low volatility financial strategies. Jeff can be reached at email@example.com.
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