Most writings for advisers are directed to helping clients in or near retirement, for the same reason why Willie Sutton robbed banks: That's where the money is. But more attention is due to those just entering middle age, who still have the time to avoid their parents' mistakes. This second part of columns on Young Investors is directed at clients in their 20s through 40s.
Get Off the Hedonic Treadmill
If you observe friends and coworkers after they get a raise, you will usually see them react in the following five stages:
- Glee
- Satisfaction—at being validated
- Indulgent—enjoying spending extra
- Irritated—at their higher tax bill
- Confused—at how their glee evaporated so quickly
Economists call this the "hedonic treadmill": More income leads to more spending, but more spending generates little added happiness. We quickly become accustomed to our new spending level. Better to save your raises now to buy you peace of mind later. An added bonus is that if you do not enhance your lifestyle with each raise, you will need to replace less income when you retire.
Try a Budget
Only a small fraction of Americans budget their expenses. So it isn't surprising that the majority of households spend every dollar they earn—and often more.
When you retire, you will lose the ability to make up for unexpected expenses by working harder. So it is a good idea to gain the habit of spending within a constraint. Build a simple budget. It need not be elaborate; in fact, it is easier for you to conform if it has only a few, broad expense categories. Begin cultivating the habit of discipline early, so that it will be thoroughly ingrained when you really need it. This may also help you estimate your real income needs in retirement, and give you useful insight into how to implement the envelopes strategy.
Put It on Autopilot
Psychologist Daniel Kahneman won the 2002 Nobel prize in Economics for his work (with Amos Tversky) explaining how real people make real financial decisions, as opposed to how economists theorize decisions are made. In his Thinking, Fast and Slow, he argued that we all have two cognitive systems: System II is careful and deliberative, relying on evidence and logic (slow), while System I is intuitive and mercurial—and fast. But engaging System II involves mental effort that no one has in unlimited supply. So we often fall back on System I, that uses shortcuts and rules of thumb (that Kahneman calls heuristics)—and often is wrong. As a result, we often default to whatever the status quo is.
