Understanding cognitive biases can help us to make good quality decisions. If we know where we’re likely to go wrong with our thinking, we can take conscious steps to counter these tendencies.
A recent working paper, “The role of time preferences and exponential-growth bias in retirement savings”, discusses two biases that make us less likely to save money. (HT: The Atlantic)
These biases are:
- Present bias. We tend to give stronger weight to options with immediate payoffs than options with payoffs that are at some point in the future. That is, we are wired to spend now rather than save for the benefit of our future selves.
- Exponential-growth bias. Even if we intellectually understand the power of compound interest (and many people don’t), it is difficult to intuit the profound impact of compound interest/exponential growth in a way that has a concrete effect on our behaviour. In other words, we don’t realise how much a dollar saved today will be worth in the long-term future.
At a policy level, schemes like Kiwisaver, which are opt-out and lock funds away until retirement, are a way of countering present bias and taking advantage of the exponential growth that compound interest brings.
At a personal level, having a savings plan and committing to this plan, in a way that is automatic, and keeps funds out of easy reach, is a great way to battle these biases.
(And when I say “savings plan” in this context, I also mean a “debt reduction” plan. Because reducing debt has the same effect on your net worth as saving money.)