Self-control bias. A $50,000 SUV will cost you $872,000 without a proper asset allocation strategy.
Self-control bias is a lack of short-term discipline for long-term goals. Investors with this bias prioritise immediate satisfaction over retirement savings, leading to financial risks and lower living standards. Creating a financial plan, executing it methodically, and understanding the power of compound interest can help optimise portfolios and overcome this bias. Discover whether you are prone to a self-control bias and the extent to which it affects your investment decisions with PRAAMS BehaviouRisk.
Behavioural science. What is self-control bias?
This bias refers to a lack of short-term self-discipline when pursuing long-term goals. Consider saving enough for retirement, a very typical financial goal. The self-disciplined investor will put aside money regularly, for instance, from monthly salary or annual bonus, sacrificing today’s pleasure for tomorrow’s benefits. An investor with severe self-control bias will make an investment decision to spend his current income on expensive discretionary items because he values today’s satisfaction more than the remote joy of a good pension. When retired, the former will maintain a high standard of living, while the latter will probably see it drop sharply and need to rely on others to make do.
Self-control bias is an emotional bias, i.e., an error in emotional reactions. These biases are more difficult to overcome and require permanent discipline and control in addition to awareness.
What are the consequences and portfolio risks?
People with severe self-control bias often fail to create a retirement plan or to save enough for retirement. Being motivated by short-term consumption, such investors tend to invest less than the plan requires or buy securities of a higher-risk profile, hoping for quick significant gains to fund both current consumption and retirement needs. Almost inevitably, such excessive investment risk-taking results in losses. As retirement approaches, such investors increase their risk appetite and try to invest in even higher-risk assets to compensate for both previous losses and lost time. Worse, their natural tendency to invest in securities producing current income (to consume it) rather than long-term wealth worsens the situation.
What can I do to make my portfolio optimal?
First, it is worth having a financial plan, ideally long-term, that covers retirement. A simple estimate of your earning capabilities while working and your spending needs when retired will give a reasonable estimate of how much you need to invest. Nowadays, many simple applications are available to do this for you. Creating an investment policy statement (IPS), a document summarising your long-term investment objectives and constraints is even better. However, a good IPS usually requires the paid services of a portfolio management services professional.
Secondly, for investors with severe self-control bias, the issue is not just about having a plan but also about executing it methodically. Discipline in everyday spending is crucial. The idea of dollar-cost averaging — a simple investment strategy aimed at investing equal amounts of money to buy securities regardless of price may appeal to you. It should encourage you to invest regularly and worry less about a security’s price and market timing, thus making self-control bias less acute. Another simple yet fascinating motivation is compound interest. Smart investors know that an interest rate of 1% becomes 1.2% yearly, on average, if invested for 30 years. Not much, in fact. A 5% annual interest rate gives a 332% return over 30 years, or 11.1% yearly on average. This is way better; more than double! And 10% invested for 30 years becomes an average of 54.8% annually — an even more astonishing multiple. The lesson is to invest consistently and start early.
The idea is that today’s dollar is much more valuable than tomorrow’s because of interest rates. Consider the following example. You want to buy a new Volkswagen SUV for $50,000 today, a reasonable sum to spend on a practical family SUV. But ask yourself: Will you pay $216,000 for the exact same Volkswagen? Of course, not! This sum would buy an outstanding Porsche or an Aston Martin, not a family SUV. And, of course, no one would spend $872,000 on any Volkswagen! The trick is that these are the sums you lose from your retirement money if you purchase the SUV today. $50,000 is equivalent to $216,000 at a 5% interest rate and $872,000 at a 10% interest rate. Spending instead of investing is worth a second thought.
