The Psychological Reasons Why People Fail to Save
Garrett Shinn, CPA
A new paper has found that two biases prevent people from saving money. These two biases are “present bias” and “exponential-growth bias”. “Present bias” refers to the trend, when evaluating two future options, to give stronger weight to the earlier option as the decision gets closer. “Exponential-growth bias” is a perceptual bias that relates to an individual’s understanding of compound interest.
An individual with present-bias preferences might originally intend on investing a refund he will receive in six months, but when the time comes, does not invest. The only change that occurred was the passage of time. This individual will not save as much as another person that does not suffer from present bias and does not change their mind when the time comes. The commonplace name for this bias is procrastinating. A good example of people exercising this bias is at the dentist. People often explain their desire to want to floss more in the future but then when asked whether they flossed yesterday, the person is speechless.
An individual who neglects compounding will expect retirement account balances to grow linearly over time, while one who incorporates it will expect them to grow exponentially. This individual will save less because he believes the expected return to saving to be less than it really is. Although most young people do understand that saving money now is better than saving money the year before they retire, they often underrate the benefits of compounding interest.
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