The increasing culture of consumerism makes savings rather difficult for everyone. This culture has made it even tougher to encourage young working professionals to start their retirement savings early in their career. In this article, applying behavioural psychology, we discuss measures that can enable you to start your retirement savings early.
There are two reasons why you should save early for your retirement. First, consider the rule of 72. The number of years it takes to double your investment is approximately 72 divided by the returns on your investment. That is, if you expect to earn 10 per cent on your total portfolio investments, you may be able to double your portfolio value in 7.2 years. So, longer your investment horizon, higher the benefits that you can expect to gain from compounding of returns.
For example, if your investment horizon is 15 years, your initial portfolio value may increase 4 times — double in the first 7.2 years and then again in the next 7.2 years. If your investment horizon is 30 years, you can expect to earn 16 times the initial portfolio value. Of course, the power of compounding works in your favour only if your investments are in interest-bearing instruments such as fixed-deposits. This is because, unlike equity, fixed-deposits generate only positive returns, as nominal interest rate cannot be negative. It is sufficient to know that the power of compounding does more harm than good when you have equity investments.
This brings us to the second reason why you should start your retirement savings early. Because you will necessarily have equity investments and because such investments may have negative returns, compounding could have adverse effects on your portfolio. In such circumstances, a longer investment horizon offers you a greater chance of recovering losses on your investments before you retire. Despite the benefits, few young professionals start early. Why?
CONSUMPTION VS SAVINGS
You can benefit from current consumption today whereas you reap the benefits of saving only in the future. You, therefore, choose to consume more today at the expense of not saving early for your retirement. Behavioural psychologists call this tendency to prefer the present and discount the future as present bias.
How can you moderate present bias? We apply two concepts from behavioural psychology to help you moderate present bias. One is procrastination and the other, priming. Consider procrastination. We typically prefer to make right choices in the future, not today. That is why dieting is easy to practice in the future, not today, as is savings. Taking cue from this behaviour, we want you to commit today 20 per cent of your future incremental income every year to retirement savings. So, if your monthly salary were to increase by Rs 10,000, you should set aside Rs 2,000 towards your retirement savings. Importantly, you should implement a process today to automatically debit the amount when you receive the salary increase next year.
Next, consider priming, a subtle presentation of an idea that can impact your behaviour. You can impact your savings behaviour using visuals. That is, instead of saving for an abstract goal- accumulating, say, Rs 25 crore for retirement — work towards specific objectives such as saving for an Alaskan cruise, post-retirement. Research has shown that you can be nudged to save more if you can visualise your goals. Further, have a simulated image of your “older” self in your computer desktop to help you relate to your old age.
There are two reasons why you could fail to achieve your investment objectives. One, you do not save enough. And two, your investments generate lower-than-expected returns. You can control your savings, not returns on your investments. So, improve your chances of achieving your investment objectives through disciplined savings. Start saving today for retirement.
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