Wednesday, December 19, 2012

Want to Save More? Automate and Simplify!

I have some new numbers on an old problem, the emergency fund. We all know that we need to set aside something for a rainy day. The financial gurus recommend that we have between three months and eight months take home salary in something like a bank account or a money market fund. How many Americans actually have that kind of cushion against the slings and arrows of outrageous fortune? From the Winter 2012 edition of Charles Schwab onInvesting:

28% Have No Emergency Fund
21% Have Less Than 3 Months in an Emergency Fund
17% Have 3 to 5 Months in an Emergency Fund
25% Have 6 Months of More
9% Declined to Answer

I have seen and reported on numbers that are worse than those seen in this survey. Why don’t people do a better job preparing for both the known unknowns, (when will I need to buy another car), let alone the unknown unknowns like hurricane Sandy? Sheena Iyengar has studied the human decision making process. She has discovered there are four keys to making better decisions. I will add one more to that list.

The first key to saving for a better future is automation. Set up an automatic debit on your checking account that goes straight into savings. If you never see that money, as with a pretax deduction for a 401K, it is even better. A one time decision takes the burden off your memory and puts at least a little money out of harm’s way every week or every month. If you do not yet have a bank account, that is no excuse. The envelope system used by your great grandparents will work just fine. Every time you receive some money, put a predetermined amount in an envelope, preferably that envelope should then be locked in a box.

Sheena Iyengar has discovered that too many choices results in paralysis. There are thousands of individual stocks and mutual funds out there. Which one do I choose? Her studies indicate more fund choice in a 401K program actually lowers participation. People, afraid to make the wrong choice make no choice even if they know they are harming their own future.

Her next recommendation is concretize your decision making process. The more vivid the consequences of a decision, the more likely you will make a good decision; asking the participants in a 401K to write down a couple of benefits of saving money for retirement on the plan application form dramatically increased participation.

Categorize! Humans deal with choosing categories, then making particular selections better than confronting complexity. Stores have discovered that people confronted with 300 magazines in an unorganized rack seldom make a decision. If the magazines on the racks are clearly separated by category, people are more likely to buy. I would zero in on the financial section, maybe travel if planning a vacation, or pro football in the late summer.

Finally condition for complexity; in a study of purchasing a new car, Sheena Iyengar discovered the customer would become more engaged in the sales process if first presented with a simple choice, a four cylinder engine or a V-6 then with the more complex choices culminating in choosing between something like 56 different color combinations. If the sequence was reversed it is easy to lose the customer.

How does this work. Once you have that emergency fund in place, start simple. Start with something you understand. I understand the concept of an integrated oil company. They sell gasoline. I buy the stuff every week. Oil companies make a lot of money in good times and in bad, so one of my first stock purchases was Chevron. In my mind, at that time it was either Chevron or Exxon, a simple choice. My wife went through a similar process choosing Johnson & Johnson. She likes their products and trusts the company.

For picking mutual funds or exchange traded funds start with a fund family or a category depending on your situation. For example if you are heading from the general to the particular, Vanguard is the unchallenged king of low cost funds. Fidelity is also a well respected fund family with a wide variety of options. If heading from the particular to the general, say an emerging market exchange traded fund, just do a Google search then dig into the particulars of each offering, especially sales load and total fees.

Picking funds for your 401K can be a little more complex. If you can’t deal with complexity consider a life cycle fund that invests in a balance of stocks and bonds their managers think appropriate for your age. As you learn more, you can begin to make your own decisions as to particular funds and fund mix.

So there you have it. Go and do it. Getting started is the hardest choice. Once you learn that it works, increasing your savings rate and making more complex financial decisions will, surprisingly, seem very easy and natural.

1)Automate Your Savings Process
2)Cut the Number of Choices
3)Make it Real
5)Condition Yourself for Increasing Complexity

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