Lately I've been studying behavioral finance's applications to retirement planning, so you'd think that I wouldn't succumb so easily to common behavioral finance mistakes such as unrealistic optimism and hyperbolic discounting. But you'd be wrong.
I made a few of these common blunders during a recent visit to Amsterdam and came away with a better appreciation of the pitfalls we all face when planning our retirement. Let me tell you what I learned.
The scenario: I was bike riding with my wife in the countryside outside Amsterdam on a beautiful summer day. We faced a choice: Return the rental bikes by 5:45 p.m., or wait until the next day, which had a forecast of rain. This far north in the world, the light is golden well into the evening, so returning the bikes by 5:45 would deny us many hours of beautiful sunlight. But if we returned them the next day and it rained, we'd need to ride across town for about 30 minutes to the bike shop, and we'd get soaked.
So, what should we do? Live for the moment and stay out past 5:45? Or make the prudent choice and return the bikes, avoiding the potential for a miserable, wet ride the following day?
We didn't spend much time thinking about it: We decided to keep riding well into the evening. After all, we were enjoying our time now, and tomorrow seemed so far away. This is classic "hyperbolic discounting" at play -- enjoying today at the expense of tomorrow. This phenomenon often plagues people when they're trying to save money for the future but also face so many other good ways to spend their money today.
At the time, my wife and I thought that somehow it would all work out the next day -- we'd deal with the rain if it happens. After all, weather forecasts are often wrong, aren't they?
That's "unrealistic optimism" influencing our decision, just as it does with so many people who tend to think that somehow things will work out OK, even if they don't do much planning or saving for retirement. Why listen to those so-called retirement experts who are constantly admonishing us to save more for retirement?
So, what happened? We woke up the next morning to pouring rain and the prospect of a drenching ride across town. Oh, the regret! Why didn't we believe this could happen? What were we thinking when we kept riding our bikes the night before?
I've often heard similar laments from people who started their Social Security benefits at age 62, the earliest possible age to collect, but with the lowest benefit. Now they're in their 70s, wishing they had waited for the increased monthly income that comes with postponing your benefits, because they could really use the extra money.
My wife and I hastily devised a backup plan: We'd avoid the rain by returning the bikes the following day and incur another day's rental fee. This would be costly, which is typical of backup plans you make up as you go. Likewise, many people realize that they should have saved more money for their retirement years but didn't, so they'll just keep their noses to the grindstone and continue working, because they need the money!
My wife and I moped around for awhile, wallowing in our misfortune. Then we noticed that it had stopped raining! We hopped on the bikes and raced across town, keeping one eye on the threatening clouds, hoping the sky wouldn't open again. We just made it to the rental shop when the downpour started again. In my gratitude I vowed to learn something useful from our experience.
What should we have done differently? We could have slowed down and spent a few minutes contemplating the consequences of our hasty decision. If we had vividly imagined the miserable, wet bike ride, we might have made a more prudent decision the day before.
Similarly, many people don't spend much time at all thinking about the future. If they would just stop and think about the unpleasant consequences of being broke and old -- and the regret they might feel -- they might decide today to make plans for the future.
One such exercise to help you do this is to use software that "ages" a photo of yourself and shows what you might look like in 20 or 30 years. Thinking about this "future self" might influence you to take action today to make life better for that future you.
Our bike-riding experience also provides another example of life's uncertainties. It really did turn out OK for my wife and me because we were able to return the bikes without incurring an additional fee. And that's what makes retirement planning so tricky: Some people will get lucky even though they made decisions that weren't very sensible. On the other hand, many people don't get so lucky.
As for me, I'm not going to count on getting lucky when it comes to my well-being in my later years. I don't want to experience poverty and regret because I didn't take time to plan my future and just hoped it would all work out. After all, hope is not a good strategy!