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.
With the benefit of hindsight, this period looks like the Golden Age of stock investing, a time when investors felt they could wade into the market with great confidence that their principal would return a healthy profit. Today, that mindset seems like a quaint memory of a bygone era exacerbated by a press that seems all too willing to predict the next recession.
The role of odds and chance: Although there is much skill, reason, and understanding involved in making a good investment, these findings reflect how number numbness keeps investors from understanding the odds and role of chance in their investing. There's nothing any single investor can do about the facts presented here, and it's not dumb luck that has produced these kinds of returns over time. But the numbers can be intimidating, and a short-term loss can scare an investor away.
Such findings as these make a pretty good case for the buy-and-hold strategy of investing, but the stock market is only one part of a retirement planning strategy you could consider. There are any number of other ways you can accumulate a nest egg-all those ways simply have to fall within your risk tolerance and comfort zone.
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Such a stance can keep you from succumbing to a mind trick called hindsight bias.
"People who experience hindsight bias misapply current hindsight to past foresight," according to Hersh Shefrin in his book Beyond Greed and Fear. The previously held emotion may not have been terribly strong, but the subsequent experience can reinforce the emotion to the point where you think your premonition was just as strong.
If you were making an investment in a commodity such as grain, and a grain investment that year turned out to be lousy because of weather, you may say after the fact that you should have known the weather would not be good for your investment. But no one can predict the weather for an entire growing season, especially when a single storm could negate an otherwise optimal growing season.
We had a tremendous snowstorm here in Colorado a couple years ago that swept through in a hurry and delivered several feet of snow. The storm came in so quickly that many ranchers could not get out to their fields to retrieve their cattle and get them under shelter, which resulted in huge financial losses for the ranchers. Odds and chance also play a part in long-term investing.
Finally, there's the part of number numbness called bigness bias. Think about the reference to inflation I covered a few paragraphs ago. During the late '70s, inflation was easy to notice because it was in the double digits. From 1982-2000, it was almost impossible to notice because it was often at only 1 per cent or 2 per cent annually.
Because investors simply saw the big stock returns during this 18-year-long bull market, they didn't realize that inflation was actually taking a little bit of the purchasing power out of the dollars they were earning. To look at it another way, when something is incrementally small, such as 1 per cent inflation or a 2 per cent annual return on an investment, you tend to overlook it, as it falls into that opaque category we have discussed throughout the book.
But small numbers add up to big numbers. For example, hypothetically, if you pay 4 per cent for a loan when you could pay 3 per cent, that 1 per cent can add up to a big number and can make a big difference in one's retirement plans over time.
Investor Errors of Miscalculation
Numbers are the essence of evaluating outcomes and opportunities in investing, involving time, rate of return, and magnitude of losses and gains. Unfortunately, when you involve more than a couple of variables, people often become confused and make the wrong decision. Our tendency to miscalculate can impact everyday decisions. Are you a basketball fan?
Down by Two, Seconds Remaining, What Play Do You Call?
Let's say, for example, that in basketball, the odds of making any given two-point shot are about one in two, or 50 per cent. The odds of making any given three-point shot are about one in three, or 33 per cent. So, if you have the ball and just a few ticks left on the clock and your team is down by two points, what play do you call for your team? The vast majority of coaches call for a two-point play in hopes of tying the game and sending it into overtime. The odds of them winning with such a strategy are about one in four, or 25 per cent. This is because victory is dependent upon two consecutive events: making the shot and then winning in overtime, both with 50/50 chances of happening.
Option A-Go for the Win
Shoot the three-point shot
Odds of making: 33 per cent
Option B-Play for Overtime
Shoot the two-point shot
Odds of making: 50 per cent
Win the game in overtime
Odds of winning: 50 per cent
25 per cent chance of tying game AND going on to win in overtime
Pure number crunchers would say the hands-down better play is to shoot the three because it provides an 8 per cent higher chance of victory. Some basketball traditionalists, on the other hand, might argue that you try to extend the game by taking the easier two-point shot and then try to win in overtime. A coach is rarely criticized for following "prevailing wisdom" by going for the tie and overtime. But is it the right call?
It might be tempting to summarize this issue and conclude that the technical analysis tells you to take the three-point shot. Using this logic, one colleague of mine-a well-published behavioral economist-argued vehemently with me that this was the best course of action. However, he never played basketball and seemed to be missing an understanding that "averages" can delude very easily, and some other complex factors are involved in this scenario. For example
• Does your team have, or lack, exceptionally good three-point shooters (as compared to the average)?
• Is the other team particularly good (or poor) at defending the three-point shot?
• Are you playing in front of the home crowd or on the road?
• What's the timeout situation?
When you consider all the factors that must be processed, interpreted, and used to make a split-second decision, it becomes clear why the guy two rows from the top of the arena does not get a vote in which play is called. It is precisely this complexity, and a coach's ability to sort through the noise and make the decision that gives his team the win, that determines his success or failure, and ultimately his career.
When it comes to our financial playbook, the situation is eerily similar. We receive many inputs from number crunchers and behavioral experts alike. At the highest levels, we may understand the rules of thumb when it comes to how much we need to plan for retirement, and perhaps even how our personal biases tend to discourage the behaviors necessary for success. However, that understanding alone is overly simplistic and disregards a host of complex and intertwined variables. For example
• How much can you afford to take from your portfolio each year in retirement?
• Will you need to make adjustments to the income you take to account for inflation?
• How will changes in tax rates impact your retirement plans and what can you do to insulate yourself from uncertainty?
• How can you resist temptation to chase market performance and hide from market rallies?
• What options are available to capitalize on your beliefs of where the economy, markets, and tax rates are headed?
Fortunately, like the team owner who employs a highly qualified coach, you have the opportunity to work with a highly qualified adviser who can process the variety of inputs and help keep you on the right path to your financial goals. Let's consider another example: taxi drivers.
A lot of taxi drivers make a serious monetary miscalculation when they quit working after attaining a given daily goal. For example, they might go home after they have earned $200. Predetermining the amount of money they intend to earn in a day is a benchmarking mistake, as each day presents different variables that can make it a good day or a bad day for a cab driver. The result is that they end up working much shorter hours on the very lucrative rainy days, when everyone is looking for a cab, and giving up the opportunity to earn much more money. Conversely, when a cabbie works much longer hours on sunny days when cabs are plentiful, he gives up the opportunity to do something that may be more profitable or enjoyable than trying to meet the $200 threshold he's set for himself driving the cab.
"Opportunity costs," according to Daniel Kahneman, Amos Tversky and Richard Thaler, "typically receive much less weight than out-of-pocket costs." It's conceivable that if the cab driver were to maximize the opportunity to earn money when the weather was bad, he'd easily earn an average of $200 a day.
When investors try to calculate the returns on their portfolios, they often don't bother to use calculators. Instead, they will eyeball the returns or rely on their memories. And when they do, they often make the wrong decisions.
Consider this hypothetical example: Cindy and Ben both make a one-time investment of $10,000 and let it ride for 30 years. Cindy earns 10 per cent on her money, and Ben earns 5 per cent. How much more will Cindy earn over the 30 years than Ben does?
A. 5 per cent more
B. Twice as much more
C. 30 per cent more
D. Four times more
Many people quickly assume that Cindy's investment will earn twice as much as Ben's will. After all, 10 per cent is twice as much as 5 per cent. This error is particularly eye-opening because, when you look at the actual numbers, you can see that the answer is D-Cindy would actually earn over four times as much as Ben in 30 years.
Excerpted from Retirementology: Rethinking the American Dream in a New Economy, with permission of FT Press, an imprint of Pearson.