The following passage is excerpted from Retirementology: Rethinking the American Dream in a New Economy, by Gregory Salsbury. Please join our online reader discussion with Mr. Salsbury on Monday at noon (ET). Just fill in your email address in the live blog box near the bottom of the page.
Number numbness—The tendency for a person to be simply overwhelmed by numbers presented, mainly because the numbers are so big that the person can’t comprehend exactly how big they are.
Bigness bias—Whether it’s inflation or compound interest, people have a tendency to overlook small numbers such as 1 per cent or 2 per cent. However, over time, those numbers become big. So whether people are paying a small percentage per year on their credit card interest or earning small interest on an account, the overall sum that is paid or earned is actually very big.
Hindsight bias—People often believe, after the fact, that some event was predictable and obvious when it was not predictable based on the information they had before the event took place. A person who’s unsure about making an investment might believe, after the investment goes up, that he did have the information ahead of time that told him that the investment would be a positive one.
Number Numbness Multiplied by Three
In their book Why Smart People Make Big Money Mistakes and How to Correct Them, authors Gary Belsky and Thomas Gilovich report the three ways that number numbness can affect long-term financial plans. The first is that you don’t take taxes and inflation into effect. The second is that failure to understand the odds and the role of chance can cause you to make unwise financial decisions. Third, many people have an indifference to small numbers, and that bias can cost them big bucks when it comes to their financial plans over time.
Failing to account for taxes and inflation: Let’s take a look at inflation. Many of you remember the inflation of the late ’70s and early ’80s. It was well into double digits and spawned something called the Misery Index, which combined the unemployment rate at the time with the inflation rate.
The result of all this was an economic “malaise” that no one wants to repeat. Measuring inflation then was easy. Anybody who had a loan or wanted to borrow money was reminded of it daily. In December 1978, the prime rate stood at a now unfathomable 11.75 per cent. Yet within two years, by December 1980, the prime rate had skyrocketed even further to a record 21.5 per cent. Increased borrowing costs squeezed the budgets of corporations and individuals, and economic activity was essentially choked off. Rates can also exemplify the problem of failing to account for inflation.
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Since 1982, we have embarked on a tremendous economic expansion that would take us through the dot.com bust at the millennium. During that period there was only one recession of note. But one thing that people forget about during that era of general prosperity is that inflation still existed. It may have been 1 per cent or 2 per cent annually, but it was still there. Even at that low level, inflation was doing what it always does: taking away purchasing power from consumers, especially consumers on a fixed income, such as retirees.
Because the rate of inflation was relatively low, however, people didn’t pay much attention to it. Instead, they looked at their nominal returns over those years. A person who invested in the stock market on January 29, 1982, when the DJIA was 871.10, didn’t necessarily have 12.5 times more buying power with that money on January 31, 2000, when the Dow was 10,940.53.7 Many dollars that were invested in the stock market in 1982 and stayed there for the following 18 years increased many times in value, at a rate that far outpaced inflation.
