Being aware of our behavioural biases could mean a significant increase in retirement savings. There are two common biases that can affect how we save for retirement:
1. Present bias – the tendency to put more value in current or short-term decisions than the future
2. Exponential-growth bias (EGB) – the tendency to underestimate and neglect the power of compounding investment returns.
A person with present-bias may intend to save more in the future but never do so; while a person with EGB will underestimate the returns to savings and the costs of holding debt.
All is not lost, however, as understanding your own biases is the first step to creating a proper retirement savings plan to fund the lifestyle you want when you stop working.
Self-awareness has the potential to reduce the impact of our biases. For example, a person who is aware of his/her EGB could rely on the market to acquire tools or seek advice, and a present-biased person could use committed arrangements to control the impulses of his/her future self.
It is proven that people who understand their EGB, hence accurately perceived the power of compounding, had about 20% more savings than those who neglect compounding completely.
So what does this mean? Be aware and keep check of your biases, and your retirement nest egg could be a lot bigger.
Most investment advisors including myself, believe that building and maintaining a diversified portfolio is the most prudent way to help clients invest their money.
Not only do numerous studies of asset class returns back this up, but no matter how smart and experienced the advisor is, it’s near impossible to predict with consistency which asset class (e.g. stocks, bonds and cash) will outperform in any given time frame.
Studies on long-term investing have shown that more than 90% of the variations in a portfolio’s return can be attributed to the asset allocation decision.
That isn’t to say that it doesn’t take skill and expertise to build a diversified portfolio – it does – there are many metrics that come into play such as growth prospects, valuation metrics, and global economic trends.
The truth about diversification is that a truly diversified portfolio will not provide the return of the best performing asset class over a given time period, nor will it match the return of the worst performing asset class. The return will be somewhere in between. Which is exactly the point – the highs are less high but the lows are less low making it more likely that an investor will not panic and change strategy at exactly the wrong time. This applies to both professional and individual investors.
The truth about diversification is that it isn’t a strategy designed to predict which asset class will outperform each year, but rather to gain from the outperformance in some asset classes while avoiding the lows in others and in the end producing solid average returns. Liken it to the Tortoise and the Hare story…as the Tortoise said: “slow and steady wins the race.”