How to be a smarter saver

First published: Parade Magazine, 10 May 2009

Not very long ago, Americans were terrible savers. In 2007, the average person put aside 60 cents of every $100, or .6% per paycheck. However, the current economic downturn has shocked us into depositing more at the bank. As of February, the personal savings rate was more than 4%. That’s a big improvement, but it’s still half of 1980s levels, when Americans routinely socked away 10% of their paychecks. Why is saving so hard? And how can we be smarter savers?

Behavioral economists—researchers who mix psychology and economics—have uncovered three reasons why people find it so difficult to save. The first is temptation: Although we often later regret it, we just can’t resist spending. The second is lack of understanding: Our brains can’t quite grasp the profitability of saving. The third is optimism: We believe that everything will work out, even if we don’t save.

Fortunately, researchers have found solutions to these problems. Temptation can be countered if you make saving as much fun as spending. This isn’t such a stretch. Neuroeconomist Ben Seymour of University College, London, sits in front of a brain scanner and watches what happens in our heads when we think about financial decisions. He found that imagining a future purchase is almost as good as getting it. For example, when we daydream about buying a new car, our brains respond in much the same way as when we actually make the purchase.

We can harness this buzz to our benefit by discarding vague ideas of “saving for a rainy day” and focusing instead on particular items we need or want. “Saving is much easier when it’s for something specific,” Seymour says. Reinforce this connection in your mind by opening a different savings account devoted to each of your goals: one for a new car, one for a vacation, one for a child’s college tuition fees.

Or try this effective technique: Remind yourself to save whenever your paycheck comes. Write messages in your calendar or set up your computer or e-mail program to give you periodic prompts. Dean Karlan, an economist at Yale, has tested this method in experiments in countries such as the Philippines and Bolivia. He discovered that even low-income bank customers managed to deposit some of their wages when they were nudged to do so by regular text messages. “That beats the argument that people just don’t have the money,” Karlan explains.

Researchers Jonathan Zinman of Dartmouth College and Victor Stango of the University of California, Davis, have discovered another reason that we don’t save:  We forget about the power of compound interest—how, say, $10,000 invested at a 5% interest rate will almost triple in 20 years.

“Almost everyone severely underestimates how much interest they can earn on their savings,” Zinman says. The same cognitive glitch applies to how we think about debt. Millions of Americans pay interest rates of 20% or more on their credit-card balances, and these high rates will make even a modest amount quickly balloon. Never under-estimate how much debt costs and how much your savings can grow.

Richard Thaler, a professor and behavioral economist at the University of Chicago, is convinced that there’s just one way to save. “Having an amount automatically deducted from your paycheck is the only thing that succeeds,” he says. “If we have to decide with every paycheck how much we should put aside, the answer is often zero.”

However, all of this research on better ways to save does not shed light on why such large numbers of Americans were steady savers in the past and why so many gave up on the practice. Economists Ulrike Malmendier of the University of California, Berkeley, and Stefan Nagel of Stanford believe that our attitudes toward risk are strongly shaped by the economic conditions we experienced when we were teenagers or young adults.

Over the last two decades, stock prices rose strongly and downturns were relatively gentle. As a result, those who grew up during this period became optimistic about future investments and willingly took big risks. Older investors, shaken by the poorly performing stock market of the 1970s, acted with much more caution.

Thanks to the present financial turmoil, today’s teenagers will probably have much less trouble saving when they hit adulthood. They’ll have seen firsthand that saving is not about using your money to invest and make a killing on stocks or real estate; it’s about putting some of your money safely aside in an uncertain world. That’s a lesson we should all start to learn.

18th of June, 2009HighlightsOther Writing • Comments off