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Beware of Magical Thinking

In our society, which increasingly demands individual financial responsibility, workers need to take control of their retirement plans. While this should be obvious enough, for many people, "control" translates into hoping for "good luck to come along down the road."

Magical thinking
This mentality may be explained by a growing field called behavioral finance, which studies psychological influences on financial decisions. Researchers in this field have done research on a number of interesting concepts, such as anchoring and loss aversion, but perhaps the most fascinating is magical thinking -- the irrepressible belief that good luck will come along and make everything all right.

In Irrational Exuberance, Yale Professor Robert Shiller gives examples of psychological experiments that demonstrate magical thinking:

  1. People will place larger bets on a coin that has not been tossed than a coin that has been tossed with the result concealed.
  2. If asked how much money they would demand to part with a lottery ticket they already hold, people will demand four times more money if they have chosen the numbers than if the numbers were randomly generated.

Of course, people are aware that they do not have the ability to influence the outcome of a coin flip, and the odds of winning the lottery are the same whether you use random numbers or "lucky" numbers. Yet people will bet more, implying that on a certain level they believe in a mystic influence over the coin or the numbers.

Retirement in Wonderland
To see magical thinking at work in the real world, look no further than the 2006 Retirement Confidence Survey from the Employee Benefit Research Institue (EBRI):

  1. 40% of workers or their spouses currently work for companies that have defined benefit (pension) plans, yet 61% of workers expect to receive retirement income from a defined benefit plan.
  2. From the fact sheet (opens pdf file), 44% of workers who have not saved for retirement believe they will have a comfortable retirement.
  3. Nearly 20% of people who have not saved for retirement expect their personal savings to provide their primary source of retirement income.

Critics of these numbers point out that the EBRI survey does not include real estate in these calculations. However, according to the age comparison study, only about 3% of workers intend to finance their retirement through the sale or refinancing of real estate. In other words, a large swath of the American workforce thinks that someday, something will turn up, and that will fund their retirement.

In the most extreme form of magical thinking, 21% of Americans believe that winning the lottery is "the most practical strategy for accumulating hundreds of thousands of dollars for retirement." The average American spends $184 per year, but the top 10% of players spend $2593 or more on the lottery. If the top 10% saved and invested, instead of playing the lottery, they would accumulate more than $288,000 in additional retirement savings.

Retirement planning beats luck
Unfortunately, blind optimism, luck, and hope are not sound retirement strategies. A retirement plan consists of creating an estimate of retirement expenses, which is supported by consistent saving and investments in sound companies. When I was 25, one of my co-workers told me, "just save your money and buy companies like Johnson & Johnson (NYSE: JNJ  ) , Anheuser-Busch (NYSE: BUD  ) , and Coca-Cola (NYSE: KO  ) . Over time, you'll have plenty of money." He retired early from his job as a machinist, with more than $1 million in a portfolio built with companies that sell the products we buy every day. Large blue chips like these pay out healthy dividends and carry less risk -- in other words, they must play a key role in any retirement strategy.

At our Rule Your Retirement service, lead analyst Robert Brokamp has many additional tips for planning a more "rational" retirement. While he may have a magical way about him when he smiles, Robert Brokamp avoids magical thinking when offering advice to his readers. Sign up today for a free trial, and get your personal finances on the yellow brick road to financial security.

Anheuser-Busch and Coca-Cola have been recommended by the Inside Value newsletter service.

Robert Aronen does not own any company mentioned, but he believes he'll have a comfortable retirement because he always wears his lucky shirt when investing.


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