Hannah Boundy, CFA®, CFP®
The Importance of Habit
Updated: May 7, 2020
There’s a saying that “knowing is half the battle.” The idea is that as long as you know about an issue, you’re halfway to resolving it. As it turns out, that might not actually be true. At least that’s what psychology researchers at Yale University have found. According to Laurie Santos and Tamar Gendler, knowing isn’t half that battle - it’s barely a step in the right direction. In what they’ve termed as The GI Joe Fallacy, their research in cognitive science has found that in many areas, knowing something is true isn’t enough to combat the biases inherent in our everyday thinking.[i] What does this have to do with financial planning and investing? A lot more than you might think.
In the last several decades, the field of Behavioral Economics has gained a lot of traction. Previously, it had been criticized for flying in the face of traditional economics which assumed that individuals operated 100% rationally at all times. After years and years of research, we’ve discovered what the mother of a toddler could have told us was true all along – sometimes people misbehave. We don’t act rationally all the time. Don’t believe me? Take a look at the picture below:
Which line is longer? At a glance, most individuals will say the line on the top. But of course, this is an optical illusion known as the Muller-Lyer illusion.[ii] As you can see below, they are the same length:
You might say, “That’s just an optical illusion. An illusion of the eyes, not of my judgment.” Then again, when asked if they’re above average drivers, more than half of individuals will say yes (which isn’t how averages work). Not only that, but individuals consistently overvalue their own property and undervalue that of others, they consider sunk costs when making decisions, they are persuaded by the way decisions are framed (hello advertising) and on and on. We are irrational people. And when it comes to finance, this matters because the decisions we make with regards to our money have pretty significant consequences.
BUT, as I just said, knowing this is not half the battle. It’s very likely that reading this article isn’t going to change your habits. So, what then do we do, particularly when it’s our financial goals at stake? The short answer is that we look for logistical levers that can help us modify our habits. What I mean by logistical levers are ways to automate our decisions based on what we do know in an effort to skirt our behavioral biases and bad habits. One excellent example of this is automating our savings contributions. In his book Misbehaving, economist Richard Thaler discusses the success of 401k programs that require participants to opt-out rather than opt-in.[iii] On our own, we are pressed to choose to reduce our current income for the sake of our future selves. This is just another example of irrational thinking but it’s very prevalent. Even though we know we should contribute to our retirement accounts, simply knowing isn’t often enough to spur us into action. If, however, our employer automatically enrolls us in a plan, we’re more likely to go along with the enrollment – the byproduct of which is we begin to accumulate the savings necessary to retire. Another excellent automated option when it comes to retirement savings is contributing future raises. While automatic 401k enrollment is a great start, it’s often not at a rate high enough to meet most individual’s future needs. At the same time, contributing 10-15% of your paycheck, something we routinely encourage our clients to do, may seem impossible. Luckily, many 401k plans are also starting to offer the option to contribute future raises such that as your income rises, you automatically contribute more, thereby helping you fight your own behavioral shortfalls.
When it comes to the actual process of investing, there are even more behavioral shortfalls to consider – things like overtrading one's account from a false sense of confidence, buying securities that may not be good investments but that the investor is familiar with (individuals often like to buy large amounts of stock in the companies they work for despite the risks of having a large, concentrated position). Again, just knowing that we are prone to poor investing habits isn’t enough to prevent them. What we can do however is look for ways to counter our bad habits. We can put processes in place that force us to acknowledge where our biases cause us to fall short and push us to do the rational thing, even when it creates dissonance in our minds. One of the best examples of this is finding ways to be mindful of our propensity for taking risk. When it comes to the dangers of our irrational behavior, selling out of a down market because we can’t handle the volatility can have a truly harmful impact on our ability to meet financial goals down the road.
If you’re considering outsourcing some of your financial decision-making to a financial advisor, just remember that financial advisors are also human beings and are susceptible to their own biases. When interviewing a prospective advisor, consider asking what their processes are for making financial decisions and what levers are in place to encourage thorough due diligence and accountability. One great question to ask is if decisions are made individually or by committee. It’s much easier to encounter biases when we hear diverse perspectives and must argue our position than when decisions are made in the solitude of one’s own head, where behavioral biases typically reign.
As you seek to pursue healthy financial habits, don’t forget that while knowing won’t necessarily change your behavior, it is the first step in recognizing that behavior may need to change. Education is still powerful, as is informed conversation and can be a great starting point for brainstorming helpful ways to modify your financial behavior for the better.
[i] Santos, Laurie R, and Tamar Gendler. “2014 : WHAT SCIENTIFIC IDEA IS READY FOR RETIREMENT?” Edge.org, Edge, https://www.edge.org/response-detail/25436.
[ii] Donaldson, J, and F Macpherson. “Müller-Lyer.” The Illusions Index, University of Glasgow, https://www.illusionsindex.org/ir/mueller-lyer.
[iii] Thaler, Richard H. Misbehaving: the Making of Behavioural Economics. Penguin Books, 2016.