- Today, I’ll discuss Thaler’s Save More Tomorrow concept and the behavioral issues that impact how much we save and invest.
- Secondly, I’ll dig into how much someone is supposed to save and invest to reach a future target.
- I’ll conclude with this question: are you saving/investing enough?
Yesterday, we discussed Nobel prize winner professor Richard Thaler’s findings in the field of behavioral finance.
Thaler’s findings can really help us to lower our investment risks and increasing our returns. However, investing isn’t only about picking the right stock or properly timing a trade, it’s also about carefully allocating our capital in investing in the first place, thus saving for investing.
So today I’ll discuss another very interesting concept developed by Professor Thaler, one that discusses how we can take advantage of our behavior to save more, in this case, tomorrow, which should lead to higher financial benefits in the future.
The Save More Tomorrow Concept
The save more tomorrow concept started out as a way to help people solve their money managing mistakes. The fact that 50% of Americans don’t have a 401(k) savings plan isn’t a good sign. From a behavioral perspective, owning a 401(k) makes saving easy because you don’t see the money that you are saving as it’s usually automatically invested into something instead of going to your bank account.
Going deeper into the savings pattern, only one out of every 10 Americans save enough and Thaler’s research has shown that only half a percent of Americans actually save too much.
Now, the question all investors should ask themselves, before they even start thinking about investing in stocks or other asset classes, is whether they are saving/investing enough.
The reason so few of us are saving enough comes from our self-control. Humans prefer instant gratification, even if that gratification is smaller than a future sum that they’d have to wait for, and it’s difficult for us to control our actions.
Further, investing can be overwhelming. It’s much easier to spend extra money on a trip than to carefully invest it in an asset because it takes a lot of time to learn about investing.
Another interesting thing is that people usually frame their savings as a loss because they have to cut their spending, and as we saw yesterday, loss aversion is one of the pillars of behavioral finance.
So there are a few behavioral issues that prevent us from allocating enough money to savings and investing. What Thaler and his partner Benartzi devised is a plan to save more when you get a raise where you automatically invest more in your 401(k), and have even more left for spending. With this, they’ve solved loss aversion as you don’t have to cut your spending. They’ve also solved the self-control issue as they automatically invest more when they receive a pay raise, avoiding the moment when people tend to lose control.
Thaler and Benartzi tested their approach on a small Midwestern company in 1998 and they asked people to save more when they got a future paycheck. This resulted in people saving 13.6% of their paycheck 5 years later instead of the 3.4% they were saving prior to the Save More Tomorrow savings plan.
The Save More Tomorrow plan has really gained traction since 1998, and is part of the Pension protection plan proving that academics really can help people and the economy.
This leads me to the the all-important question.
Are You Saving Enough?
The easiest investing target to analyze is retirement. Do you know when you plan to retire? How much will you get from social security benefits? Will it be enough for the lifestyle you expect? Is what you are investing now enough to reach your goal?
These questions take a lot of time to answer as each personal situation is different. Nevertheless, the value I want to leave you with today is that very long term expected returns from the current market are around 4% for stocks and even less than that for bonds. So then, you have to ask yourself, if you have a pretty large portfolio and you plan to retire in the next 5, 10, or even 15 years, would the 4% be satisfying? And the funny thing is that 4% is the best case scenario. In the case of a diversified corporate bonds and treasuries portfolio, you can expect 3% long term returns. Just to make the case stronger for those expected returns, it isn’t me who invented them, those are Jack Bogle’s expectations.
These returns are extremely poor when compared to past performance, therefore it’s extremely important to either save more or to learn much more about investing in order to reach higher returns with the same amount of risk.