The two blind spots that stop us seeing the need to invest

Posted by Robin Powell on April 12, 2016

The two blind spots that stop us seeing the need to invest

 

Think of behavioural finance and you generally think of the biases that damage investment returns — herd mentality, recency bias and overconfidence, for example. But what about the biases that stop people investing in the first place or, for those who have started saving, stop them investing as much as they should?

A new study by economists from Stanford University, the University of Minnesota, London School of Economics and Claremont Graduate University, finds that there are two key biases more than any other that cause us to make insufficient provision for retirement.

The first is a tendency towards putting off decisions that are likely to benefit us in the long run, but which also involve short-term costs. It’s a form of procrastination which economists call present bias, and the researchers found that about 55% of us are prone to it.

The second bias is a failure to understand the power of compounding investment returns and how this can build wealth over decades of saving. The researchers refer to it in their paper as exponential-growth bias. Nearly 70% of us, they found, fail to appreciate the benefits of compounding.

The findings were based on an online survey of nearly 2,500 Americans with an average age of around 49. Those who were not affected by present bias had, on average, about 19% more in savings than those who were, in other words, those who were reluctant to accept short-term pain for long-term gain. Those who had a good grasp of the power of compounding had about 20% more money saved than those who neglected the benefits of compounding altogether.

Interestingly, the study also concludes that present bias and exponential-growth bias are two distinctly different blind spots. The message for policy makers and the investment industry is that attempts to persuade people to invest more should focus on these two biases separately.

And what are the lessons for individual investors? First, obviously, you need to be aware of these biases. But also, crucially, you need to realise that you yourself may be prone to them; indeed the odds are that you are affected by at least one, if not both, of them.

So, don’t procrastinate. Start investing now. If you need to invest more, invest more. And remember, the longer your money compounds, the faster it will grow.

You can read the study here:

The Rôle of Time Preferences and Exponential-Growth Bias in Retirement Savings

 

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Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.

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