“Human decision-making is complex. On our own, our tendency to yield to short-term temptations, and even to addictions, may be too strong for our rational, long-term planning.” – Peter Singer
“Truly successful decision-making relies on a balance between deliberate and instinctive thinking.” – Malcolm Gladwell
We all like to think that we are good at making decisions. The problem is that as human beings we let our emotions get the best of us in the short-term and that hurts our long-term results.
We all have cognitive biases that get in the way of making the right choices that will help us in the future. There is a tendency to go with the herd with our decisions called the bandwagon effect. The confirmation bias causes you to search for information in a way that confirms your own position or belief.
Framing allows different people to view the same information and interpret it in a completely different way. Our negativity bias causes us to pay more attention to negative news and experiences than positive ones. And the recency bias causes you to put a disproportionate weight on most recent events and extrapolate those events going forward.
What does all of this have to do with how to manage your money? Actually quite a bit. I once read that success is the product of rational thinking. Sounds easy enough but as you can see from the short list of biases that I outlined we are not always rational.
We let our emotions get the best of us. It’s hard enough for some people to plan ahead for next weekend let alone the next decade or even retirement that can be thirty or forty years into the future.
If we are forced to constantly make decisions we can be our own worst enemies. We don’t always make the obvious choice that will be good for our situation in the long-run even though we know better.
People know that smoking is bad for them. They are told this at an early age. There are even labels on the packages. They have seen the long-term statistics. But the short-term effect of that cigarette is easier to grasp than the long-term effects. The same thing applies to weight loss (eat less, workout more) and your savings (spend less than you earn).
Let’s look at the organ donor system to see this in practice. Germany uses an opt-in system for organ donors (they have to make the decision to join the program). The consent rate is 12% among its population. On the other hand is Austria, a country with a very similar culture and economic development, but which uses an opt-out system for organ donors. Austria has a consent rate of 99%.
These are similar cultures, but with different mechanisms for decision-making. The act of having to opt-in to the system is obviously one step too far for the Germans. But when given the choice to have to opt-out, the Austrians stay in the program. That doesn’t mean the Germans are bad people and the Austrians are all humanitarians. It boils down to the processing of their decisions for this program.
When you determine how to manage your money you need to set up a system more like Austria, where you are forced to opt-out and less like Germany, where you are forced to opt-in. Technology allows us to take away the difficult decisions and put them on auto pilot.
AUTOMATE YOUR SAVINGS
I’m sure you’ve heard the axiom “pay yourself first.” It’s a worn out phrase in the personal finance industry. In fact, this is the very phrase that David Bach uses in his book, The Automatic Millionaire. In the book he outlines how the slow and steady process of setting up automatic deductions from your paycheck or checking account every month is the best way to slowly build wealth over time.
But I think you can take this approach one step further and put your entire universe of financial decision-making on auto pilot.
The first and most important decision to put on auto pilot is your savings. If you have a workplace retirement plan like a 401(k) your job is that much easier. You can pick a percentage of your salary or an exact dollar amount to be taken out of your paycheck every single time you get paid.
For starters, I recommend saving at least enough to get the company match but feel free to go above and beyond that amount. In fact to retire comfortably you will need to save more.
If you don’t have a retirement plan with your employer you can still set up an automatic withdrawal from your checking account each month with an IRA (Individual Retirement Account). Any fund company can easily set this up for you in about an hour (think Vanguard, T. Rowe Price or Charles Schwab).
Again, you can set up a set dollar amount to be automatically taken out of your account each and every month (remember to save early and often to take advantage of compound interest). Many people become paralyzed at this step in the process because they don’t know what to invest in. Just start by saving and then move on to figuring out how to invest. How much you save will have a disproportionate effect on your end goals as opposed to what fund vehicles you invest in.
You can do the same exercise for your emergency savings account. Or your vacation fund, wedding fund or house down payment. Whatever the reason is that you are saving can be put on auto pilot. I recommend using an online savings account like Capital One, HSBC or Ally (they are cheaper to run online so you get slightly better rates). Pick an amount and have it taken out automatically.
Not only does this take the decision-making process out of your hands, you end up treating your monthly savings like a bill payment. You know it will get taken out automatically so you know you can’t spend that money.
The fact that you don’t have to write a check every month and mail it in to the fund company is a huge advantage for growing your savings. That one decision makes it all so much easier. To stop the savings process you have to opt-out which is the point.
And setting up your savings on auto pilot makes it a much simpler process to increase the amount you save over the years as your salary increases or your situation changes. Just increase the amount you save every time you get a raise until you reach the amount that will allow you to reach your long-term goals.
AUTOMATE YOUR BILLS
Once you have taken care of the savings decision you can move onto the rest of your financial picture. Bills can be automated. You can have all of your utilities, monthly memberships (gym, Netflix, etc.), insurance, car payments, student loans, credit card payments and even your mortgage set up to be paid automatically.
This is a powerful tool to help you avoid paying late fees, interest and missing payments all together. An unintended benefit here could be that your credit score improves (having on-time payments helps).
You should be able to set up these automatic payments directly through the companies that you are paying or through a bill payer with your bank. No matter how you set it up, the more payments you can have coming out automatically the better.
Set up all of your accounts and your common sense budget is set for you. You will know exactly how much you have leftover each month because all of your savings and bill paying is already done in advance.
Now you can use the leftover money for food, entertainment, gas or whatever else you spend your money on each month. People hate having to set up and track a budget. Well now you don’t have to. You can just plan for your future goals and spend the rest. Problem solved.
If you happen to be in debt you can also put your debt repayment on auto pilot to force yourself to pay it down. You can even increase the amount you pay each month to speed up the process. And once you have the debt kicked by paying it off on a periodic basis you can transition those funds to be saved for retirement or an emergency savings account.
AUTOMATE YOUR INVESTMENT PLAN
Once you have all of your investment accounts set to auto pilot to save for you each month you can go about automating your investment plan. Through your 401(k) or IRA provider you can set up an automatic rebalance schedule to get back in line with your desired asset allocation mix.
I would advise that you do this at least annually but monthly, quarterly or semi-annually would work as well. It depends how much you are willing to let your assets deviate from their target weights.
Rebalancing not only keeps you within your stated risk profile but it also forces you to sell what has gone up to lock in gains and buy what has gone down or lagged to buy low and sell high. I think you may have heard this phrase before.
Another benefit to putting your retirement savings on auto pilot is the fact that by saving on a periodic basis you are setting yourself up to dollar cost average into the market. This takes away the temptation to time the market. It also spreads your bets in a volatile market. When markets are up, your periodic investment will buy fewer shares than usual. When the markets are down you will actually be buying more than usual.
AUTOMATE BUT PERFORM MAINTENANCE
Just remember that putting your finances on auto pilot does not mean that you can totally neglect them altogether in the future. You must perform a little check-up every once and a while to make sure that you are still on track to meet your goals. Your risk profile and time horizon may also change if you are facing different circumstances in your life.
Setting up automatic triggers within your long-term savings and every day personal finance life will make it easier for you to avoid the cognitive biases I described at the outset of this post. Will it always keep you from making irrational decisions? Of course not.
You may still be tempted to make moves that have the potential to hurt you in the long-run. But once you start seeing some results like the slow build up in your retirement and emergency savings funds it will be much harder to change the auto pilot feature and opt-out. Your progress will slowly snowball until you eventually see the huge benefits that you get from making long-term plans instead of short-term choices.
Use your common sense and take the decision-making power out of your own hands. That way you will not be your own worst enemy when it comes to managing your financial situation. You don’t want to spend time constantly worrying about how to manage your money.
Automation will also allow you to sleep at night without stressing about saving and paying bills on time. Just put your finances on auto pilot and worry about something more important like March Madness.