You know you should be saving but you aren’t, or if you are, you feel like you are not saving enough. Why do you do this? And how much should you be saving? Read on to find out.
As a financial planner, I come across all types of people with different relationships with money and spending/saving habits. Most families want to save more and ensure they are making the right decisions for their money based on the family’s priorities. Despite good intentions, it seems very difficult to reduce spending and save more. Why is this change in behavior so hard?
Behavioral Finance economists are working to indentify why we make certain financial decisions that run contrary to our goals, and more importantly, how to change behavior so that we make the right decisions. Shlomo Benartzi, an economist and professor at UCLA’s Anderson School of Business, sums up “why we do not save” into three behaviors:
- Desire for immediate Gratification– wanting rewards today instead of in the future. Self-control today is a problem for most Americans, “Spend today, Save tomorrow”. It is more fun.
- Inertia– a tendency to do nothing. Unless you are offered a 401(k) plan (only 50% of workers in the U.S. are eligible) and are automatically enrolled in the plan, most people do not systematically save for retirement. Even if you have a 401(k) plan, only about 1% of workers save the needed amount to reach their retirement goal. Why? Because it involves checking boxes and making investment decisions, which people avoid.
- Loss Aversion– strong preference for avoiding loss over acquiring gain. Americans tend to frame savings as a loss because it means you have to go without something today. So, they do not save.
During the recent Great Recession, the personal savings rate in the U.S. increased above 5%. Unfortunately, it does not appear that this change in behavior is sticking. By September 2011, the savings rate dropped down to 3.6%, which is around the pre-Great Recession rate. How much should you be saving?
According to Elizabeth Warren’s Balanced Money Formula, you should spend 50% of your net income on “needs”, 30% on “wants” and 20% on savings. If you earn over $200k per year, have two kids and own a home in the Bay Area, you likely take-home about $160k. This means you should spend $80,000 on needs, $48,000 on wants and $32,000 on savings. The amount is not really important; you have to do what works for your family. Getting in the habit of saving is more important!
So, how can you reframe savings and implement a strategy that overcomes a desire for immediate gratification, inertia and loss aversion?
My advice: 1) Set your savings goals, 2) Put the infrastructure in place, and 3) Start autopilot. Let’s say that you dream of taking a three week vacation to New Zealand (expected cost ~$15k) with your family in five years and feel like you will never be able to afford it. Consider this, if you set up a $50 per week automatic transfer from your checking account to an investment account earning 5%, you would have the $15,000 needed in five years for your dream trip.
I am a big fan of weekly automatic withdrawals from checking accounts. Usually, you don’t miss the money because it is a relatively small amount, it is automated (inertia be damned) and you won’t feel the loss of this money if you never knew it was there.