The Psychology of Passive Investing

February 15th, 2012 by 
CameronDaniels

For the most part, people who frequent personal finance sites have better control than the general public, but they also harbor a dangerous attitude. Many posts about the savings rate of America curry responses decrying the lack of self-control of the general public. I know that I have fallen victim to my own  questionable personal finance decisions before... Is it because I was completely unaware? No.  Is it because I didn't care about the impact? No.  I'll prove it: today we'll discuss the Psychology of passive investing.

The bad decisions I made were usually because I did not understand the gravity of the decisions I was making at the time.  For example, my decision to attend an expensive private university (even though I currently have no regrets) may have been different if I had considered all the angles.

Nudges and Shoves

  • Do you want to create an emergency fund?  Easy.  Spend four months building one.
  • Do you want to retire at age forty? Not a problem.  Control spending now and begin investing in tax-sheltered investment vehicles.
  • Do you want to reduce your money spent on gas? Simple.  Hypermile!
The Psychology of Passive Investing: Picture of $20 bills.

Psychology of passive investing: Turning off your mind may be the easiest route

The ease with which I answered these questions I posed is common to some - but definitely not the norm.  That's why it's worth looking at some nudges and shoves which will help others with their spending goals over time, often by using Psychology in interesting ways.

The Save More Tomorrow program is an economic, behavioral and psychological prescription for controlling spending / saving habits. The program is simple... The participant does not save any more money today, but promises ahead of time to devote a certain portion of future pay raises to savings. In this way, once an employee gets used to a certain amount of spending, they can save more simply with future raises. In a few studies, this has shown to increase the savings rate of participants from 3.5% to 11.6%. Does this imply that those who wish to save (such as these participants) are simply willing but unable? What does this mean to those who believe that they have a good handle on their finances?

The 'Magic' Of Automatic Savings and the Psychology of Passive Investing

Perhaps the best way to continue one’s path to financial independence or early retirement is to set up automatic contributions or investments. Devoting a portion of one’s paycheck (outside of an employer-sponsored 401k) to a dedicated saving/investing account can be the best way to turn off the mind and just get money into investments. The amount of the automatic investment is not what is important: any investment will simply “reduce” the amount of money you have to spend, skimp or save. This method also has the added benefit (debatable...) of dollar cost averaging into investments, reducing one’s exposure to quick fluctuations in asset prices by spreading out purchases over time.

Does anyone have any experience trying to dedicate a portion of their paycheck (outside the 401k) directly to savings? Is there any other personal finance decision that you have made that could be improved upon (despite believing that you are in complete control of your actions)? How much do you love/hate cognitive dissonance?

Cheers,

Cameron Daniels

      


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