How Online Platforms Are Using Psychology to Help You Manage Your Money

How Online Platforms Are Using Psychology to Help You Manage Your Money

How Online Platforms Are Using Psychology to Help You Manage Your Money

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You’ve probably dreamed of magically waking up one day to see that all of your personal or business accounts have ballooned to a bazillion-gajillion-ish dollars. But it usually doesn’t work that way. (Or at least, it hasn’t for me.) In-the-moment temptations, combined with increased costs, make it super hard to save and invest. It might get a whole lot easier to set money aside and protect it, though, thanks to investment companies that purposely are incorporating psychology to curb your impulses.How Online Platforms Are Using Psychology to Help You Manage Your Money

The idea

Financial companies now give people access to “robo-advisors”–that is, online investment platforms built on technologies that can provide automatic financial guidance to help you stick to a money plan. While some robo-advisors are simpler than others, the best can help with and personalize virtually every step of the investment process, including deciding what your goals should be, automating deposits and incorporating tax considerations. All you have to do is provide basic information, such your age and what you’d like to save for (e.g., retirement).

What inspired the psych-based, automated design

Dan Egan, Director of Behavioral Finance & Investments at Betterment, says that the biggest motivator behind the current robo-advisor trend was the financial crisis that hit a decade ago.

“Before 2008,” Egan says, “much of the investment industry consisted of big financial institutions, which had little to no interest in giving consumers a fair shake. Some would even quietly encourage poor behavior through tactics like incessant emails, ads and website design. They were all designed to encourage rash, emotional reactions from consumers. They wanted people to think they had to trade now, to get a big win or avoid a big loss. They didn’t care what that meant for the customer’s portfolio, because the broker won either way.”

But now, many investment platforms carefully are bringing psychology, science and automation together. As a simple example, Betterment, which bases its platform on work by the likes of Nobel Prize winner Richard Thaler and author Carl Richards, incorporates the effect of color. The team changed when they use red and green, for instance, because people react impulsively to those colors. The platform now color codes whether your plan is on track, too, rather than color coding historical returns. Egan further claims that Betterment also uses scientific trials to figure out how to communicate with customers in ways that reduce emotional decision making and market timing.

Changing your view by letting you step back

Because people can use robo-advisors to automate investment tasks, they go a long way in getting people into the long-term money mindset that’s served Warren Buffet, Benjamin Graham John Bogle and many other money masters. You can set up what you want the platform to do and then basically leave it alone. By changing the habit of constantly peeking at what your accounts are doing, you’re less tempted to make quick-twitch modifications, and it’s easier to stay focused on your big picture. That can translate to bigger take-home growth for an individual or company–Egan asserts that investors cost themselves around 6 percent in returns each year by moving around in their investments, and that Betterment customers take home about 2.66 percent more in returns annually than investors examined in others studies.

A deficiency of forgiveness

“One drawback [to robo-advisors] is that we tend to be more trusting of humans, rather than computers,” Egan says. “If a person has a 60% success rate, and a computer has a 90% rate, people still tend to trust the human more. When they see a computer make a mistake, they say ‘you’re done’. We’re more forgiving of human error. We try to counter this by making our online advisor as human as possible. For example, we try to humanize our algorithms–basically asking human advisors questions, and turning it into an algorithm. We also show which advisors were involved in crafting the process being used.”

How to boost your odds of a smooth investment journey

Regardless of whether you use a robo-advisor or go old-school, Egan says there are multiple steps you can take to proactively reduce investment mistakes for yourself or your company:

1. Keep a financial plan diary and map out you’ll do if the market goes south. If you’ve got a plan, you don’t have to resort to knee-jerk reactions.

2. Find someone who can give you a second opinion. Ideally, this will be someone who might have a different perspective than you.

3. Focus on facts about the future, not fear of the past. “[This isn’t] always easy, given today’s technology and news cycle. You have to tune out the noise and look at the reality of your money. And you should never act based on something you just saw on social media.”

“We tell clients: If you’re feeling emotional about your investments, you should log out and do something else,” Egan concludes. “You’ll end up making a better decision that you’ll appreciate in the future.

When It Comes To Personal Finance, Don't Believe Everything You Read

When It Comes To Personal Finance, Don’t Believe Everything You Read

When It Comes To Personal Finance, Don’t Believe Everything You Read

Click here to view original web page at www.forbes.comWhen It Comes To Personal Finance, Don't Believe Everything You Read

One of the most valuable concepts I learned in studying economics is the importance of factoring in all the consequences of an action, especially ones that aren’t always apparent upfront. I was reminded of that lesson when I recently read three different financial planning articles that came to some dubious conclusions. Let’s take a look at each of them:

Is your home a worse investment than you think?

That’s what this article argues by pointing out all the expenses that reduce the return on homeownership. After subtracting mortgage payments, home upkeep, closing costs, a real estate agent’s commission, and the cost of remodeling and adding a patio to maintain average home size, the author calculates the annualized return on investing in the median home in San Mateo county, CA from 1995-2005 to fall from 23.4% before factoring in the additional costs to 10.8% afterwards. The author does have a good point in that too many prospective homeowners underestimate or fail to account at all for these costs in determining whether buying a home makes good financial sense.

However, he fails to account for the biggest financial benefit of homeownership: having a place to live. After all, if you didn’t own a home, you’d probably have to pay rent that would likely be steadily rising. If you’re going to factor in the cost of adding a patio, you’d also have to factor in the cost of moving to a home with a patio (and the higher rent that comes with it). Unlike rent payments, interest and property taxes are also tax-deductible even if that deduction is more limited now. (You can use a calculator like this to help weigh all the costs and benefits of your particular situation.)

Is a Roth 401(k) (almost) always better than a traditional 401(k)?

That’s the claim made in this blog post that compares investing the same amount in a Roth IRA and traditional IRA and then investing the tax savings from the traditional IRA contributions in a separate taxable account. With a Roth IRA, the earnings can be withdrawn tax-free after 5 years of opening the account if you’re over age 59 ½ and with a traditional IRA, the contributions can be tax deductible but the withdrawals are taxable. The problem here is how the study calculates taxes.

First, they use the same tax rate to calculate the tax deduction on the IRA contributions and the tax on the IRA withdrawals. Let’s ignore the fact that many people will retire in a lower tax bracket than when they were working and contributing and take a single person earning $60k today and retiring in the same 22% tax bracket with $40k of taxable income in retirement. When they contribute to a traditional IRA or 401(k), those contributions would normally get taxed at that 22% tax rate so they save 22% on their taxes. However, when they withdraw those dollars in retirement, only taxable income over $38,700 would be taxed at 22%. Over 96% of this person’s income would be taxed at 12% or less even though they’re in the same tax bracket!

(check out our article on What is an Individual Retirement Account)

The second problem is that the study assumes that the earnings in the taxable account are taxed at the person’s ordinary income tax rate every year. This only makes sense if the person sells all their gains in less than 12 months every year, which would be terrible tax planning. More realistically, they would mostly be paying a lower 15% capital gains tax rate for holding the investments at least a year and only when they sell. (If they avoid selling, they can eventually pass the investments on to heirs tax-free.) They can also use losses to offset gains and even some of their ordinary income taxes.

Should you take Social Security benefits at age 62?

This article gives 3 reasons why you might not want to wait. The problem is that numbers 1 and 3 are both arguments for retiring early, but as long as you have enough savings to bridge the gap, you can retire at 62 (or earlier) and still decide to collect Social Security at a later age. In fact, a research project at the Stanford Center on Longevity came up with a retirement income strategy that starts with optimizing Social Security by relaying benefits until 70 if you’re single or the primary breadwinner. This is because your benefits grow by 8% for each year you delay, which is more than you can safely expect your retirement investments to grow. Delaying can also increase benefits for a surviving spouse.

Reason number 2 was that you’ll simply collect more Social Security checks by starting early. Social Security benefits are calculated so that you’d get about the same total income if you live until the average life expectancy so it’s true that you’ll collect more Social Security income if you don’t live that long. On the other hand, if you end up living longer than average, you’ll end up collecting more and will actually be around to reap the benefit of that higher income.

None of this is to say that homeownership is necessarily a better investment than you think, that a traditional 401(k) is (almost) always better than a Roth, or that there aren’t valid reasons to collect Social Security benefits at 62. Each of these questions depends largely on the particulars of your personal situation. Just make sure that you understand the whole picture when making a decision or work with a qualified financial planner who does.