18
Emotional Bias #3: Self-Control Bias
Self-reverence, self-knowledge, self-control: these three alone lead to power.
—Alfred, Lord Tennyson (1880)
Bias Description
Bias Name: Self-control bias
Bias Type: Emotional
General Description
Simply put, self-control bias is a human behavioral tendency that causes people to fail to act in pursuit of their long-term, overarching goals because of a lack of self-discipline. Money is an area in which people are notorious for displaying a lack of self-control. Attitudes toward paying taxes provide a common example. Imagine that you, a taxpayer, estimate that your income this year will cause your income tax to increase by $3,600, which will be due one year from now. In the interest of conservatism, you decide to set money aside. You contemplate two choices: Would you rather contribute $300 per month over the course of the next 12 months to some savings account earmarked for tax season? Or would you rather increase your federal income tax withholding by $300 each month, sparing you the responsibility of writing out one large check at the end of the year? Rational economic thinking suggests that you would prefer the savings account approach because your money would accrue interest and you would actually net more than $3,600. However, many taxpayers choose the withholding option because they realize that the savings account plan might be complicated in practice by a lack of self-control (i.e., one might overspend and then the tax money might not be there when one needs it.)
Self-control bias can also be described as a conflict between people's overarching desires and their inability, stemming from a lack of self-discipline, to act concretely in pursuit of those desires. For example, a college student desiring an “A” in history class might theoretically forgo a lively party to study at the library. An overweight person desperate to shed unwanted pounds might decline a tempting triple fudge sundae. Reality demonstrates, however, that plenty of people do sabotage their own long-term objectives for temporary satisfaction in situations like the ones described.
Investing is no different. The primary challenge in investing is saving enough money for retirement. Most of this chapter will focus on the savings behaviors of investors and how best to promote self-control in this often-problematic realm.
Example of Self-Control Bias
Encouraging people to save more is a task that constantly challenges financial advisors. The “Save More Tomorrow Program,”1 developed by Professors Richard H. Thaler of the University of Chicago and Shlomo Benartzi of the Anderson School of Business at UCLA, aims to help corporate employees who would like to save more but lack the willpower to act on this desire. The program offers many useful insights into saving behavior and examining it will serve as our practical application discussion in this chapter.
The “Save More Tomorrow Program” has four primary aspects:
- Employees are approached about increasing their contribution rates a considerable time before their scheduled pay increases occur.
- The contributions of employees who join the plan are automatically increased beginning with the first paycheck following a raise.
- Participating employees' contribution rates continue to increase automatically with each scheduled raise, until rates reach a preset maximum.
- Employees can opt out of the plan at any time.
Let's examine the results of a trial of the Save More Tomorrow Program (SMTP) by a midsize manufacturing company in 1988. Prior to the adoption of the SMTP, the company suffered from a low participation rate as well as low saving rates. In an effort to increase the saving rates of the employees, the company hired an investment consultant and offered this service to every employee eligible for its retirement savings plan. Of the 315 eligible participants, all but 29 agreed to meet with the consultant and get his advice. Based on information that the employee provided, the consultant used commercial software to compute a desired saving rate. The consultant also discussed with each employee how much of an increase in saving would be considered economically feasible. If the employee seemed very reluctant to increase his or her saving rate substantially, the consultant would constrain the program to increase the saving contribution by no more than 5 percent.
Of the 286 employees who talked to the investment consultant, only 79 (28 percent) were willing to accept the consultant's advice, even with the adjustment to constrain some of the saving rate increases to 5 percent. For the rest of the participants, the planner offered a version of the SMTP, proposing that they increase their saving rate by 3 percentage points a year, starting with the next pay increase. Even with the aggressive strategy of increasing saving rates, the SMTP proved to be extremely popular with the participants. Of the 207 participants who were unwilling to accept the saving rate proposed by the investment consultant, 162 (78 percent) agreed to join the SMTP.
The majority of these participants did not change their minds once the saving increases took place. Only four participants (2 percent) dropped out of the plan prior to the second pay raise, with 29 more (18 percent) dropping out between the second and third pay raises. Hence, the vast majority of the participants (80 percent) remained in the plan through three pay raises. Furthermore, even those who withdrew from the plan did not reduce their contribution rates to the original levels; they merely stopped the future increases from taking place. So, even these workers are saving significantly more than they were before joining the plan.
The key lesson here is that people are generally poor at planning and saving for retirement. They need to have self-discipline imposed on them consistently in order to achieve savings.
Implications for Investors
As previously noted, the primary issue with regard to self-control is the lack of ability to save for retirement. In addition, there are several other self-control behaviors that can cause investment mistakes. Box 18.1 summarizes some of these.
Am I Subject to Self-Control Bias?
This section contains a brief diagnostic quiz that deals with issues of self-control.
Question 1: Suppose that you are in need of a new automobile. You have been driving your current car for seven years, and it's time for a change. Assume that you do face some constraints in your purchase as “money doesn't grow on trees.” Which of the following approaches are you most likely to take?
- I would typically underspend on a car because I view a car as transportation, and I don't need anything fancy. Besides, I can save the extra money I might have spent on a fancy car and put it away in my savings accounts.
- I would typically purchase a medium-priced model, with some fancy options, simply because I enjoy a nice car. I may forgo other purchases in order to afford a nice car. I don't imagine that I'd go crazy and purchase anything extravagant, but a nice car is something that I value to an extent and am willing to spend money to obtain this.
- When it comes to cars, I like to indulge myself. I'd probably splurge on a top-of-the-line model and select most or all available luxury options. Even if I must purchase this car at the expense of saving money for the long term, I believe that it's vital to live in the moment. This car is simply my way of living in the moment.
Question 2: How would you characterize your retirement savings patterns?
- I consult my advisors and make sure that every tax-favored investment vehicle is maxed out (401(k), IRA, etc.), and I will often save additional funds in taxable accounts.
- I will usually take advantage of most tax-favored investment vehicles, though in some cases I'm sure that details may have escaped my attention. I may or may not save something in taxable investment accounts.
- I hardly ever save for retirement. I spend most of my disposable income, so very little remains available for savings.
Question 3: How well would you rate your own self-discipline?
- I always achieve a goal if it is important to me. If I want to lose 10 pounds, for example, I will diet and exercise relentlessly until I am satisfied.
- I can often attain my goals, but sometimes I have trouble sticking to certain difficult things that I have resolved to accomplish.
- I have a tremendous amount of difficulty keeping promises to myself. I have little or no self-discipline, and I often find myself reaching out to others for help in attaining key goals.
Test Results Analysis
Questions 1, 2, and 3: People answering “b” or “c” to any of these questions may be susceptible to self-control bias. Please note that self-control is a very common bias!
Investment Advice
When a practitioner encounters self-control bias, there are four primary topics on which advice can generally be given: (1) spending control, (2) lack of planning, (3) portfolio allocation, and (4) the benefits of discipline.
Spending control. Self-control bias can cause investors to spend more today rather than saving for tomorrow. People have a strong desire to consume freely in the present. This behavior can be counter-productive to attaining long-term financial goals because retirement often arrives before investors have managed to save enough money. This may spur people into accepting, at the last minute, inordinate amounts of risk in their portfolios to make up for lost time—a tendency that actually places one's retirement security at increased risk. Investors should pay themselves first, setting aside consistent quantities of money to ensure their comfort later in life, especially if retirement is still a long way off. If investors are past age 60 and have not saved enough for retirement, then a more difficult situation emerges. A careful balance must be struck between saving, investing, and risk-taking in order to increase the pot of money for retirement. Often, these investors might benefit from examining additional options, such as part-time work (cycling in and out of retirement) or cutting back on consumption. In either case, emphasizing paying oneself first—assigning a sufficient level of priority to future rather than present-day consumption—is critical.
Lack of planning. Self-control bias may cause investors to not plan adequately for retirement. Studies have shown that people who do not plan for retirement are much less likely not to retire securely than those who do plan. People who do not plan for retirement are also less likely to invest in equity securities. Advisors must emphasize that investing without planning is like building without a blueprint. Planning is the absolute key to attaining long-term financial goals. Furthermore, plans need to be written down so that they can be reviewed on a regular basis. Without planning, investors may not be apt to invest in equities, potentially causing a problem with keeping up with inflation. In sum, people don't plan to fail—they simply fail to plan.
Portfolio allocation. Self-control bias can cause asset allocation imbalance problems. Investors subject to this bias may prefer income-producing assets, due to a “spend today” mentality. This behavior can be counter-productive to attaining long-term financial goals because an excess of income-producing assets can prevent a portfolio from keeping up with inflation. Self-control bias can also cause people to unduly favor certain asset classes, such as equities over bonds, due to an inability to reign in impulses toward risk. Whether they prefer bonds or equities, investors exhibiting a lack of self-control need to be counseled on maintaining properly balanced portfolios so that they can attain their long-term financial goals.
Benefits of discipline. Self-control bias can cause investors to lose sight of very basic financial principles, such as compounding of interest or dollar cost averaging. By failing to reap these discipline profits over time, investors can miss opportunities for accruing significant long-term wealth. Investors should focus on the benefits of compounding. There are a number of very effective software programs that can demonstrate that even a minimal, 1 to 2 percent disparity in returns, if compounded over decades, can mean the difference between a comfortable and a subpar retirement. To return to an example that arises frequently in discussions of willpower—the matter of exercising—the benefits of self-discipline in investing, as in physical fitness, are difficult to obtain. The results, however, are well worth it.
Note
- 1 Richard H. Thaler and Shlomo Benartzi, “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving,” Journal of Political Economy 112(1): 5164–5187.