3 Ways to Grow Your Savings by Thousands of Dollars

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Do you ever wonder why lottery winners sometimes go bankrupt, even after winning big? Why some people keep balances on their credit cards and pay high interest rates when they have savings available to pay the bill?

And why it seems so hard for Americans to set aside regular savings for retirement, even though they know they should?

These paradoxes can all be traced back to one concept you may have noticed is gaining attention as of late: behavioral economics.

The idea of psychology as a driver of economic action dates back at least to Adam Smith’s The Theory of Moral Sentiments (1759). Behavioural economics has, however, only in recent years been getting more popular.

In 2017, the Nobel Prize in Economics was awarded to Richard Thaler, professor of behavioral science and economics at the University of Chicago Booth School of Business. Dr. Thaler’s research looked at why people often make irrational decisions with their money.

Instead of acting rationally and having self-control, we tend to get easily distracted from long-term goals by short-term rewards, we often make poor financial decisions when we know better, and we give in to impulses way more than we should.

The bad news is marketers have figured this out and they’re constantly sending you small “nudges” telling you about special offers, limited-time sales, and never-before-seen deals encouraging you to spend your money now instead of saving it for tomorrow.

The good news is you can apply these same psychological strategies to boost your retirement savings.

Using Small Nudges to Improve Your Savings

In 2008, Dr. Thaler and Cass Sunstein, a legal scholar, wrote a book called Nudge: Improving Decisions about Health, Wealth, and Happiness. Dr. Thaler defined nudges as something that “alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives. To count as a mere nudge, the intervention must be easy and cheap to avoid.”

“Nudges are not mandates,” the authors write: “Putting fruit at eye level counts as a nudge. Banning junk food does not.”

This idea of nudging extends beyond health and personal finance. Several countries around the world, including Britain, Germany and Japan have started implementing “nudge units” within their governments to change citizen behavior.

But for today’s discussion we’ll focus on how you can use little nudges to save more, invest more, and meet your retirement savings goals faster.

Nudge 1: Commitment Devices

Commitment devices are voluntary, binding arrangements that people make to reach goals that may otherwise be hard to achieve. Commitment devices are not a new concept.

From “Christmas club accounts” designed to help you save for holiday expenses, to CDs, financial providers have offered commitment savings products for decades now.

Why do commitment devices work?

  • People are present-biased – People prioritize today’s desires and needs over tomorrow’s and, as a result, fail to make choices that will only benefit them in the future.
  • People lack self-control – People often intend to save money for a bigger expense, but find themselves spending it on more tempting and gratifying things, instead.
  • People are inattentive to the future – It can be difficult to remember the future. People often under-save because they don’t think about how much money they’ll need in the next month, year, or decade.
  • Social pressure – Many people face pressure from their family and friends to share their earnings and savings.

Commitment savings devices have helped a lot of people save more than they would have otherwise. Studies suggest that people would rather be nudged than shoved into commitment savings though.

Here’s an example:

In Kenya, researchers found that simply providing people in pre-existing savings groups with a safe box (a metal box with a key they controlled), increased preventive health product investments by 75 percent in the following year.

However, a hard commitment device – where people put money for preventive health in a locked

box, and could not withdraw it for emergencies – had a much smaller impact over the same one-year period.

Nudge 2: Defaults

Automatic (“opt-out”) enrollment is when you are automatically enrolled in a product or service unless you choose to opt out. Setting the default to “opt-out” instead of “opt-in” has been shown to significantly increase uptake of certain savings vehicles, especially in retirement planning.

Why do defaults work?

  • People prioritize today over tomorrow – People tend to get caught up in their busy lives and systematically fail to make decisions today that will only affect them in the future.
  • People put off taking action on complex tasks – People often avoid taking action on tasks that seem daunting or complex, and financial transactions like choosing a 401(k) plan are no exception.
  • People suffer from inertia – People have a strong preference for the status quo, regardless of whether it is better or worse for them than available alternatives.

Research around the world suggests that defaults affect savings at every step of the way, from the rate at which people participate in savings programs, to the amount people contribute, to the likelihood that people will increase their contributions over time.

Especially in the U.S., we’ve seen the dramatic effect defaults have on retirement savings plans. One study found that when companies began automatically enrolling new hires in a 401(k) plan, participation rates went from 59 to 95 percent.

When the employer changed the default contribution rate from 3 percent to 6 percent, it increased retirement savings amounts without reducing participation rates. The 6 percent default doubled the amount of people who contributed 6 percent of their pay, from 24 to 49 percent.

Nudge 3: Reminders

A lot of people struggle to build good savings habits because there are so many seemingly urgent needs today that it’s hard to save for tomorrow, or they simply forget. Setting reminders is an easy, low-cost way to bring savings goals to the top of your mind.

Why do reminders work?

  • People tend to be inattentive to their future needs – People often fail to think about or budget for large future expenses – think weddings or a new roof, or emergencies, which are hard to budget for.
  • People prioritize today over tomorrow – People tend to put their current desires ahead of their future needs, even when they are tempted to buy something they know they shouldn’t. Temptation today makes saving for tomorrow hard.
  • People procrastinate – People often get caught up in their busy lives and delay taking action. They may intend to deposit money in a savings account, but never seem to find the time.

Research from different countries around the world show that reminders are a useful tool in fighting procrastination and helping people follow-through on their goals.

For example, Canadian online robo-advisor firm Wealthsimple started using a system that provides personalized, frequent alerts (displayed when clients sign in to their accounts) to inform them about possible investment options, like unused RRSP or TFSA contribution room.

“The idea is to proactively educate clients about the opportunities available to them – such as contributing to a retirement account. As this is personalized and immediately useful information, our hope is that it will nudge them to make decisions that are aligned with their longer-term interests,” says Dave Nugent, Wealthsimple’s chief investment officer.

As you can see, gradual changes or “nudges” can make significant shifts in financial behavior. If you’re ever feeling stuck, don’t look to make big moves right away. Instead look for small nudges that can change your course.

To a richer life,

Nilus Mattive

— Nilus Mattive
Editor, The Rich Life Roadmap

The post 3 Ways to Grow Your Savings by Thousands of Dollars appeared first on Daily Reckoning.