Fuel Your 401(k) with the Secrets of Behavioral Finance

There are simple steps you can take to apply the theories of behavioral finance to your own 401(k) and improve your financial future.

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Joseph Puhy / Gallery Stock

I used to be the prototypical bad investor. I paid far too much attention to financial news. I bought and sold on a weekly basis (sometimes daily). I chased hot stocks. I panicked and sold when the market dropped. Perhaps unsurprisingly, I also lost a lot of money.

Eventually, I grew wiser. As I became better educated about money (and about investing), I began to make smarter choices. And once I started to read and apply the lessons of behavioral finance — that fun branch of financial philosophy that combines investing with psychology — the returns in my retirement accounts really started to improve.

One of my favorite books on behavioral finance is Why Smart People Make Big Money Mistakes (and How to Correct Them) by Gary Belsky and Thomas Gilovich. (Disclosure: Belsky regularly contributes articles to Time.com.) The authors boil down the lessons of behavioral finance into easy-to-follow advice. They write, for instance:

Any individual who is not professionally occupied in the financial services industry (and even most of those who are) and who in any way attempts to actively manage an investment portfolio is probably suffering from overconfidence. [...] Such people — again, probably you — should simply divide their money among several index mutual funds and turn off CNBC.

Here’s how you can put the theories of behavioral finance into practice with your 401(k) and other retirement accounts.

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Have a Plan
Why you’re investing should inform how you’re investing. If you’re investing to save money to buy a home in five years, you’ll make different choices than if you’re a 23-year-old funding a 401(k) for the first time.

To start, create an investment policy statement, which is like a blueprint for your investments. An IPS will help you decide how much to invest in stocks and how much to invest in bonds. It’ll also help you stay on course instead of trying to take shortcuts (by doing things like chasing hot stocks) or panicking when things fall apart (like during 2008′s market crash).

By keeping your goals in mind, you can avoid common investment mistakes.

Pay Yourself First
Most folks save for retirement with whatever’s left at the end of their paycheck. The problem is that it’s easy to come up with other uses for the money, so there’s never much leftover for the 401(k). If you’re serious about boosting your retirement savings, do the reverse. Invest first, and live on whatever’s left over.

Ignore Financial News
Financial news can be dangerous to the health of your retirement. Why Smart People Make Big Money Mistakes cites a Harvard study of investment habits. The findings?

Investors who received no news performed better than those who received a constant stream of information, good or bad. In fact, among investors who were trading [a volatile stock], those who remained in the dark earned more than twice as much money as those whose trades were influenced by the media.

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When it comes to investing, ignorance really is bliss. Make your decisions based on your financial goals and a pre-determined investment strategy, not on whether the market jumped or dropped yesterday.

Use Dollar-Cost Averaging
The stock market has historically shown strong returns over long periods; you can take advantage of this by ignoring short-term market movement and making regularly scheduled investments, regardless the market’s condition. This is called “dollar-cost averaging”.

Critics of dollar-cost averaging argue that it provides a lower return than investing a lump sum now. This is true. If you have a choice, you should always invest early instead of waiting to spread the investments over time.

However, dollar-cost averaging is an excellent technique for those who can’t afford to invest a large sum at one time. It’s also what you’ll do by default if you contribute to an employer-sponsored 401(k) plan through your paycheck.

Make Automatic Investments
When it comes to saving for retirement, you are the weakest link. You’re the one who messes things up, not the market, not the economy, not your broker. Be smart. Head to your company’s HR department and ask them to set up automatic contributions to your 401(k). This takes the human element out of the investing equation, which is one of the best ways to increase investment performance.

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Bank Your Raises
Another great way to boost your savings is to set aside money from a raise. When most people get a raise, they increase their spending to match. But you’re smarter than that. Instead of succumbing to lifestyle inflation, set any raises to increase your retirement savings until you’re saving the maximum amount. You won’t even notice the money is missing.

Don’t Follow the Herd
Don’t pay attention to the latest “hot” investments. Instead, rely on historical trends to make your decisions. If you do what everybody else is doing, you’re likely to get burned. That’s how folks went bankrupt during the housing bubble. It’s how they lost big bucks during the market collapse of 2008-09. Instead of doing what everyone else is doing, stick to your guns. Follow your own plan. And remember the wise words of Warren Buffett: “Be fearful when others are greedy. Be greedy when others are fearful.”

Don’t Touch the Money
Once you start building a big balance in your 401(k), it can be tempting to move the money around. Resist the urge.

At least once each year, a friend will tell me that they’re leaving their current job, and they’re cashing out their 401(k) when they do. To my friends, this sounds like a great idea. It gives them instant cash for a car or a house or a boat. But they don’t realize this short-sighted move means they’ll have to work many more years before they can retire.

Taking the money out of the account negates all of your hard work (especially when you consider the penalties you pay). And every time you move the money from one fund to another, you end up paying fees, fees that take away from potential profits.

Common-Sense Investing
How do you put all of this knowledge to work? The answer is simple: Set up automatic investments into a portfolio of index funds. After that, ignore the news no matter how exciting or scary things get. Once a year, go through your investments to be sure your asset allocation still matches your goals. Then just continue to put as much as you can into the market — and let time take care of the rest.

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If you plan to do all your investing through your employer’s retirement plan, it’s easy to get started:

  1. Contact HR to have retirement contributions automatically taken out of your paycheck. You should contribute at least enough to get your full employer match, if you’re offered that perk. But more is better. (The single factor with the greatest impact on your savings at retirement will be how much money you’ve contributed.)
  2. Review your fund options (which may be limited). Many company plans don’t offer index funds. In that case, find funds that have low costs and are widely diversified. Sometimes your only choice will be a target-date fund — and sometimes you won’t even find that!

If your employer-sponsored plan doesn’t offer a lot of choices, ask HR if it’s possible to get more. They might say “no,” but then again, they might expand the company’s menu of mutual funds. It never hurts to ask.

Ultimately, the most important thing isn’t how you invest, but that you do invest. When you’re just starting out, your contributions have a bigger impact on your success than any other factor. So make a commitment to your future self: Get off the couch and set up you’re 401(k) today!