Cognitive Bias and why automatic saving will make you rich
You need a plan for automatic saving, because you're brain is stupid. I know it's usually not a good idea to insult the reader in the first sentence, but it's not just you. I'm a little stupid, too. So is pretty much everyone else.
In this post, I'm going to talk about the concepts of cognitive bias, mental heuristics, and decades of research in cognitive science that says that you are very likely to continue doing stupid shit like spend more than you earn. Hopefully, by the end you'll realize that you need to start getting your brain out of the way as much as possible. I also realized I promised you $150 in the title. We'll get to that.
You're an idiot
If you don't have automatic saving systems already set-up, then I want you to start automatically saving today. The best thing you can do to ensure you're successful following through with your plan to get out of debt and get rich is to get the idiot out of the equation.
I know it sounds harsh, but that idiot is you. I'm an idiot, too. The human brain is easily the must ingenious computational machine ever developed, but it can also be really, really dumb. Everyone has bouts of insanity, where their brain tells them that that boat really is a good investment.
Think of how much money I'll save on renting boats. Plus, since I'll be on the boat all the time, I won't be eating out at restaurants nearly as much. I also won't be tempted to book that cruise, since I could just go out on my boat. Hell, I think I NEED to buy a boat right now!
Yeah, something stupid like that has gone through your head. And that is exactly why you need to take the responsibility for saving out of your hands as much as possible.
Cognitive Bias is why you need automatic saving
We like to think of ourselves as rational animals. For the most part, we are. We are capable of making objective, rational decisions in many different types of situations.
However, cognitive scientists have identified our brains' ability to deviate from rational judgement due to what they call "cognitive bias."
Our brains are wired to decide on some things very quickly. From an evolutionary perspective, this is good. In the past, we had to quickly decide whether we would look around to find a big, sharp stick or run like hell when we saw a predator.
Whether we looked for the stick or laced up our sneakers would have depended on several factors. Do we have a mental history of seeing sticks lying around? Culturally, are we part of a warrior tribe or has our culture never faced battle?
You see, when we get into decision-making mode, we can't easily separate our rational thought from the sorts of short-cuts we've built over many years. Furthermore, our culture affects our decision making more than we would like to admit.
Have you looked around lately? Our culture isn't exactly enamored with the idea of cutting consumer spending and saving.
Decades of heuristic thinking
The cognitive scientists Amos Tversky and Daniel Kahneman recognized that in many situations, our thinking is dictated by simple heuristics, which are a type of mental short-cut we use to solve a problem.
These heuristics are built by our brain through the decades of our lives as we've encountered problems. We build a little procedure for solving these problems, and chug through the procedure when we face a new problem that looks similar, rather than completely solving from scratch.
Sometimes, this is pretty helpful, like when we're in a physics class. Sometimes, it's not very helpful, you know, like when we're in a physics class.
Think about how you have approached spending decisions in the past. When you look at a car ad that says you can lease a brand new car for only $150 per month, what happens in your brain?
If you're Mr. Friggin' Money Mustache, then you have ALWAYS immediately thought leasing a new car was an idiotic move. You've built a little mental short-cut that says "leasing stuff = bad." Or, "buying new stuff = dumb." Or "bikes are so much more sexy than cars." At this point in your life, you don't bother working through the math. Hell, the ad could say $10 per month and you would immediately dismiss it.
Now, let's imagine your me. When you have built a decades-long relationship with a car payment, the brain starts at a completely different place. You start thinking of that $150/month raise you just received. Hmmm, I can afford that now. And only $150/month. That's way less than the average car payment.
Here's a few you've probably used yourself in the past:
Hey, this new car gets better gas mileage. I'll probably SAVE money buying this new car vs. rocking this old beater for a few more years.
I'm only a few months away from having to replace an expensive transmission in my current car. I'll probably SAVE money off-loading it now and getting a super dependable new car.
Maybe you even do a little rationalization math.
You do this because your brain is wired to rely on basic little heuristics you've developed over your many decades of life. It's really, really hard to over-ride your immediate problem-solving process, so you spend.
In the next post, I'll talk about the concept of disequilibrium and what esoteric French philosophers have to say about how we learn new ways of thinking. Today, though, we want to get Mr. Fancy New Car away from our money as quickly as possible.
And that is why we need automatic saving plans.
Automatic saving forces you to be smart
Every month you get money from your employer or your business. You need some money to eat, but if you've got a good plan, then you won't need all of that money. What do you do with that extra money every single month?
Because of our dumb brain, we want to make sure we never have to even make a decision. We want to set-up our saving such that it just happens automagically. You want to automate as many things in your financial life as is possible.
Automate retirement savings. Boom. That money is gone and you can't spend it.
Automate extra mortgage principle payments. Boom. That money is gone and you can't spend it.
You can even hire little robots to pull money out of your account and invest it for you. Boom. That money is gone, and although you can still spend it, it's harder than if it was sitting in your checking account.
Practical steps for automatic saving
Here's what I'm doing, and what maybe you should think about doing, too.
- Determine your expenditures budget. How much do you need to live. Start here.
- Figure out how much money is left over from your income after subtracting expenditures.
- Save up a nice little liquid emergency fund for when you go over budget (you will). It doesn't need to be much. All we plan to keep easily liquid is about $5,000 for a while. You can have as little as $1,000.
- After you have that little liquid fund, have every single penny automatically funneled into your 401(k), 401(a), 403(b), IRA, whatever, until you max it out. For us, that's $18,000 per year, plus an extra $5,500 for my wife's IRA.
- Refinance EVERYTHING if it makes sense and set-up automatic extra principle payments to get your house paid off in 15 years.
- If there is still money left over, have it automatically pulled from your bank account each month and placed in a low-fee brokerage like Vanguard.
- Set-up other little systems to reach in and grab a little money here and there to accelerate your savings.
A great savings account for automatic saving
For our liquid fund, we use a savings account through Capital One 360. I initially opened an account about 10 years ago when they were ING. ING was bought by Capital One and they re-branded as Capital One 360. The service has remained phenomenal.
First, savings accounts earn interest. Since they operate completely online, then they can offer interest rates significantly higher than brick-and-mortar banks. Right now, I think their rate for savings accounts is 0.75%. It won't make you rich, but that's not what this account for.
You can also open tons of accounts if you have different savings goals and transfer back and forth between them for free and instantly.
If you link your account to another bank account, like maybe your main checking account, then you can transfer back and forth for free, as well. You can even set-up recurring transfers that happen automatically. Automatic saving. Yup.
I'm even going to be swapping my local checking account out for the Capital One 360 checking account as soon as I get back in the states (I'm in Europe right now!) Mainly because Personal Capital doesn't link with my current checking account.
Ok, so I promised to pay you $150 in the title. Here's how I'm going to do that.
Again, I'm not recommending CO360 to you because I can $20. I've just been very happy with them for a very, very long time. What you do need, though, is a savings account that allows you to set-up automatic saving.
Refinance for automatic saving?
Mortgages, student loans, and credit card debt. We'd love to be rid of it, but we're going to have to settle for chipping away at it.
For the mortgage, get some quotes and see if you can get a lower rate. If you can, then jump on it. Also, lower the number of years you pay on the mortgage. I've seen people go from a 30-year to a 15-year with almost no change in payments just from the drop in interest rate.
Consider an adjustable rate mortgage. Rate will be low for a long time. If you don't believe me, then let Financial Samurai convince you.
Once you've refinanced, set that bitch up on auto-payment.
You can also refinance student loans. I recommend you take a look at SoFiand have them give you a quick quote. I went through the process and was approved within 10 minutes for my $50,000 total student loans. I ended up with about the same interest rate (mine's low already), so I didn't jump on it. But you might have a different experience.
Here's the deal, though. I promised you $150 in the title. Here's you're chance to get some change to immediately throw at that student loan.
If you sign-up for a student loan refinance through my SoFi link, then you will get a cool $100 to chop that principle down. (They'll give me some money, too, of course.)
I'm recommending them because I found the process very easy, fast, and I love the business plan. It just wasn't the right product for me. If it's not right for you, either, then definitely keep your student loans where they are. I've heard of them offering rates as low as 2.5% for some borrowers.
Two options here. Roll those high interest credit cards on to a 0% introductory APR credit card and get them paid off. Or, get a lower rate personal loan to cover the balance. I prefer the first option, but the second option could work for you in some situations.
If you do decide to get a personal loan to refinance CC debt, then you should also take a look at SoFi personal loans. That's a different link than the one above, because it's a different product. But, the same deal applies. If you pay off your credit cards or whatever with a SoFi personal loan through my link, then you get a free $100. I'm not counting this towards the $150 I promised above, since you're probably better off rolling everything on to a new card with a low introductory rate.
If you do a balance transfer on a new card, find out how long that rate lasts. That's EXACTLY how long you have to pay that debt down. Otherwise, you might be eating the interest on the whole balance, back-dated too. Be careful with that. That's were I could see the personal loan being a smarter move.
Get a robot to fund your automatic saving plan
Next week, I'm going to do a full review of Acorns. I've been using them for about a month now and I'm kinda excited about it.
First, what Acorns does is it looks over all of your purchases during the month and rounds every purchase up to the nearest dollar. It then takes that money and puts it into an investment account.
If you spend $1.75, then Acorns will pull the extra $0.25 out and invest it for you in a mixture of stocks and bonds that you control. (It actually waits until you have $5 in "spare change" built up, and then invests.)
This is really cool. Here's how we're doing it. We don't budget these savings, since that would be hard to do. The savings for our retirement plans and after-tax savings are pulled out automatically from my paychecks ever two weeks. What's left is money for expenditures.
Acorns pulls money out of our expenditures budget. It's not a lot, but it's literally spare change we won't miss. So BAM! We are spending less and saving more.
We have $25 left to give, so you can probably guess. Sign up with Acorns through my link and we both
get $25 in our accounts. (Update: Oops. We only get $5 when you sign up using my link. Sorry about that. I'll make up the other $20 somewhere down the line.)
You need automatic saving
Wow. Whirlwind of affiliate links there. I hope that didn't distract you from the central message.
You need automatic saving set-up because your brain can do stupid stuff. If it wasn't true, you probably wouldn't be here reading this. Ignore the affiliate links if you want, but make sure you take the message and use it.
I'm going to take a little break over the weekend. However, next week I plan to write about some really bad-ass cognitive science and learning theory that we can apply to changing our money habits. I'm going to name check some fancy smart people, just like the cognitive scientists above. You just wait. I'm going to let my inner professor loose!
I'll leave you with a few questions: How are you automatically saving? Or, do you think automatic saving is stupid?