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Investor Psychology

Think Like a Squirrel

Delaying a financial decision can help give the logical part of your brain a chance to kick in.

Many of us don't have the sense God gave a squirrel. Consider this choice: Buy refrigerator A, which costs $50 less than fridge B but uses $50 more in electricity each year, or fridge B, which saves money in the long run. Select fridge B and one year later you'll break even, after which you'll save $50 annually. Yet despite the future savings, one study showed that most people faced with this decision would choose to buy the cheaper but less-efficient fridge.

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In this situation, as in many others -- notably, neglecting to sign up for your company retirement plan -- immediate financial gratification proves to be a prime motivator. That's the case even though the short-term rush pales in comparison with the long-term savings realized from picking the more-efficient appliance. Squirrels, by contrast, stow nuts for the winter even when it means skipping an acorn or two in October.

Time plays tricks on our ability to make smart decisions, especially when it comes to money. Here's another example: When offered the choice between taking $50 today or $100 a year from today, most people choose $50 now. But take away the instant gratification and the results are reversed. That is, given the alternative of receiving $50 in, say, five years or $100 in six years, most people will choose $100 in six years. Yet that's the same trade-off as with the shorter time frame.

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"We care a lot more about today than about the future," explains Harvard economics professor David Laibson. "Humans, like a lot of other animals, place full weight on what happens right now and half weight on what happens even a few days away."

That's because we react emotionally to immediate gratification and think logically about future rewards. And emotion often trumps logic. Logical thinking, including thinking about our financial future, occurs in the prefrontal cortex of the brain. This was demonstrated by Jordan Grafman, a neuroscientist at the National Institutes of Health, who discovered that Vietnam War veterans with injuries to the prefrontal cortex struggled when making long-term financial decisions. "They had a difficult time articulating goals for the future, especially far into the future, such as saving for their children's education or planning for retirement," says Grafman.

Be a noodge. So the trick to making better financial decisions for the long term is to think like a squirrel. In some cases, that's already being done for us. The study on buying a refrigerator took place in 1980. Since then the government has raised the bar on energy-efficiency standards for fridges and other appliances so that we no longer have the option of buying an appliance that's much cheaper but much less efficient. With regard to retirement savings, many employers now automatically enroll employees in the company plan when they're hired, and workers must actively opt out if they don't want to participate.

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In the book Nudge: Improving Decisions About Health, Wealth, and Happiness , authors Richard Thaler and Cass Sunstein defend such tactics as simple strategies to counteract our human limitations.

How do you nudge yourself to make better long-term decisions? Laibson suggests making time your ally. Instead of immediately tackling a daunting task, such as reviewing your entire financial plan (when you'd rather go to the movies or play golf), take the first step by making an appointment with a financial planner to rebalance your investments or work on your estate plan.

Also, delaying a financial decision by a few days can help give the logical part of your brain a chance to kick in. That shiny new Rolex that screams "buy me" when you're in the store could look like an expensive bauble when you're paying your bills.

Kiplinger's is partnering with Nightly Business Report on the "Your Mind & Your Money" series, funding for which is provided by the FINRA Investor Education Foundation. For companion video reports, tune in to NBR on your local PBS channel March 15 and 29.

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