About the Author
David Fulton is a Colorado Springs, CO fee-only financial planner providing Hourly and On-Going Financial Planning and Investment Management. While he works with a broad range of clients, David specializes in working with Active and Retired Military, Federal Employees, and Families with Special Needs Children.
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One of the first financial books I read that really stuck with me was the classic The Millionaire Next Door by Thomas Stanley. The general premise of The Millionaire Next Door is that the pop culture concept of a millionaire is false and that most actual millionaires live a very simple lifestyle. The Millionaire Next Door shows you the simple spending and saving habits that lead to more cash in the bank, and helps you avoid the pitfalls some potential future millionaires make on their way to financial independence.
The part of the book that most resonated with me wasn’t necessarily the concept of extreme frugality, which gets its share of criticism. Rather it was the more simple idea that most of us could be well on our way to a comfortable future if we just simply built habits that enabled us to meet our savings potential. The Millionaires in Stanley’s book all allocate their time, energy, and money efficiently and in ways conducive to building wealth. They budget, save, and plan their investments while they begin earning and investing early in life. These Millionaires have built the habits that drive them towards their savings potential. It's the habits that are the secret to their success.
So how do we build sound financial habits in our own lives? To fundamentally understand how habits work I turned to Charles Duhigg. Duhigg wrote a fantastic book on the subject of habit. His best seller The Power of Habit: Why we do what we do in Life and Business explores how habits work, how to instill them in our own lives, and how to harness the incredible power of creating positive habits to govern our behaviors. While not a financial book per se, I recommend you put it at the top of your reading list.
Bad Habits Aren’t Destiny
Duhigg describes habits as the brain’s way of saving energy. Your brain makes up only 2% of your total mass, but it consumes 25% of all the oxygen you intake. Your brain is always looking for ways to gain efficiency and seeking new ways to save energy. Automating behaviors in the form of habits is one of the best ways for it to do so. A study from Duke University from 2006 found that up to 45% of all our daily behaviors are automatic. If you sleep the recommended 8 hours each night, then it is likely you are spending 6 hours a day running through routines you may not even be aware of. Thus, the power of habit. If 45 percent of the actions we take daily are because of habit, it only makes sense to harness our habits to assist us in achieving our financial goals.
Through his research, Duhigg discovered that at the root of all habits lies a simple 3-part loop: cue, routine, reward. The cue is what triggers you to do the habit. The routine is the behavior you then automatically engage in. Lastly, you receive a reward for completing the routine. Your brain’s activity only spikes twice during this loop; at the beginning, to figure out which habit to engage in, and at the end when the link between cue and routine is reinforced.
Understanding how habits work provides the requisite insight for how to instill new positive habits, or how to modify those habits that are self-destructing us along the way. According Duhigg, you never truly extinguish bad habits. Rather, in order to turn from bad habits you must figure out your habit loop, identify the reward driving your behavior, the cue triggering it, and the routine itself, and only then can you begin to shift the behavior. On the other hand, good habit development seeks to modify your routine by planning for the cue and choosing a behavior that delivers the reward you are craving.
Big Gulp Habits
Habits sneak up on you. Many of us don’t even realize when we are forming new habits along the way. Seemingly innocuous things have a way of becoming sticky, and growing into problems bigger than we realize. For many years, my wife’s constant companion was a 44 oz Big Gulp. We’re talking about 44 ounces of fizzy Diet Dr. Pepper. Her desire to drink soda was not a cognitive choice. She really enjoyed drinking soda despite knowing the research identifying the deleterious effects. Knowledge by itself didn’t keep her from craving a drink two to three times a day. It wasn’t a lack of education, it was a habit. She spent years as a frequent flyer to our local gas station, then one day she just up and decided to quit. I was in awe of her willpower at the time knowing how hard it was for her to change. Now having read Duhigg’s book, I recognize how she did it, and I think it makes for a simple example of how to change a habit loop.
According to Duhigg’s framework for changing a habit you must first, identify the routine. The routine is the behavior you want to change. In my wife’s case, the habit was going to the gas station and purchasing a 44 oz. soda each time she got into her car to drop off and pick up the kids from school.
Next, Duhigg suggests you must experiment with rewards. Rewards are powerful because they satisfy your cravings, even if we’re often not directly conscious of the cravings that drive our behaviors. To figure out which cravings are associated with a particular habit, it’s useful to experiment with different rewards. My wife began her experimentation by switching to water, thinking the reward was simply the cup, the ice, and the straw. It didn’t work, she still craved soda. Next, she tried iced tea thinking perhaps it was the caffeine she really needed. Iced tea worked for a while, but it never fully satiated her for an extended period of time. Finally, she stumbled onto the crux of her craving; carbonation. Replacing soda with carbonated water became the incentive that satisfied her need. The bubbles were her reward.
Next isolate the cue. The reason why it is so hard to identify the cues that trigger our habits is because there is too much information bombarding us as our behaviors unfold. To identify a cue amid the noise, experiments have shown that almost all habitual cues fit into one of five categories: Location, Time, Emotional State, Other People, and the immediately Preceding Action. Through a thorough cataloging of each of these categories each day, you can isolate those cue’s that are driving your habit. In the soda example, the category that most drove her habit was both an associated time and a preceding action. She would crave a soda each time she got in the car coinciding with her scheduled drop off and pickup of the boys from school. Even on the weekends, her soda cravings correlated with the same time she would routinely head off to school each week day.
Lastly, you must have a plan. Once you’ve figured out your habit loop, you’ve identified the reward driving your behavior, the cue triggering it, and the routine itself, you can begin to shift the behavior. You can change to a better routine by planning for the cue, and choosing a behavior that delivers the reward you are craving. In my wife’s case, her plan was to fill up the same 44 oz. cup with carbonated water prior taking the kids to school. As a result, she no longer had the desire to stop at the gas station. She was happy, I was happy, the kids were happy.
We all have bad habits and it can be daunting figuring out where to even start. The good news, it’s enough for you to change one habit as long as it is the right one. What researchers have discovered is that some habits seem to matter more than others and picking the right habit can set off a chain reaction. They are what Duhigg calls “keystone habits”. By focusing on one pattern, many other habits will easily fall into place causing a ripple effect that affect other areas. You don’t have to start big, but you have to start with the right habit. Usually it's something that when you think about changing that habit, it seems like a cultural change. Exercise is often described as a keystone habit because people are really proud of changing it. It's something that has an emotional resonance and impacts other parts of your life.
The Story of Michael Phelps- The Summation of Small Wins
One of my favorite portions of the Duhigg’s book is his vivid example of Michael Phelps, the most decorated Olympian of all time. Michael Phelps has an immense amount of talent and incredible genetic advantages. People often focus on his 80 inch wingspan and long and lean body as to why he was so successful. While his physical attributes where important to his success, what is often less credited is how his entire life was built to capitalize on habits and routines instilled from a young age. His swimming coach, Bob Bowman, knew a young Phelps had the potential to be great, but he was often unfocused. He needed new habits to center his efforts.
Bowman focused on a few small keystone habits. The summation of small wins Bowman instilled in Phelps set the conditions for Phelps to be the first person to win eight medals in a single Olympics. Bowman’s response to the question about how Phelps prepared is indicative of the power of habit he worked to instill.
“If you were to ask Michael what’s going on in his head before competition, he would say he’s not really thinking about anything. He’s just following the program. But that’s not right. It’s more like his habits have taken over. The stretches went like he planned. The warm-up laps were just like he visualized. His headphones are playing exactly what he expected.”…. “The actual race is just another step in a pattern that started earlier that day and has been nothing but victories. Winning is a natural extension.”
Bowman ensured Phelps built routines into habits and winning happened as a result. Bowman inherently understood that if he changed just a few key habits in Phelps life he would gain a compound effect making the attainment of other good habits easier. All he needed to do was target a few specific habits that had nothing to do with swimming and everything to do with creating the right mindset.
At the core of why those habits were so effective was the keystone habit of visualization which created a series of small wins that he achieved as he modified the rest of his approach. In an effort to help focus Phelps, Bowman would tell him to "watch the videotape” and visualize the perfect race each night where he would visualize each stroke, kick turn, and finish. Duhigg describes how each night before falling asleep and each morning after waking up, Phelps would imagine himself jumping off the blocks and, in slow motion, swimming flawlessly. He would imagine the wake behind his body, the water dripping off his lips as his mouth cleared the surface, what it would feel like to rip off his cap at the end. He would lie in bed with his eyes shut and watch the entire competition, the smallest details, again and again, until he knew each second by heart.
Once Bowman established a few core routines in Phelps's life, all the other habits fell into place. He helped him develop a stretching routine that was deliberate starting at the arms and ending at the ankles. He set a routine for his warm-up, ensuring he took the same approach before each race. Nothing describes the power of the habits Michael Phelps developed like the story of his World Record setting race described in Duhigg’s book.
"Phelps knew that something was wrong as soon as he hit the water. There was moisture inside his goggles. He couldn't tell if they were leaking from the top or bottom, but as he broke the water's surface and began swimming, he hoped the leak wouldn't become too bad. By the second turn, however, everything was getting blurry. As he approached the third turn and final lap, the cups of his goggles were completely filled. Phelps couldn't see anything. Not the line along the pool's bottom, not the black T marking the approaching wall. He couldn't see how many strokes were left. For most swimmers, losing your sight in the middle of an Olympic final would be cause for panic. Phelps was calm. Everything else that day had gone according to plan. The leaking goggles were a minor deviation, but one for which he was prepared. Bowman had once made Phelps swim in a Michigan pool in the dark, believing that he needed to be ready for any surprise. Some of the videotapes in Phelps's mind had featured problems like this. He had mentally rehearsed how he would respond to a goggle failure. As he started his last lap, Phelps estimated how many strokes the final push would require – 19 or 20, maybe 21 – and started counting. He felt totally relaxed as he swam at full strength. Midway through the lap he began to increase his effort, a final eruption that had become one of his main techniques in overwhelming opponents. At 18 strokes, he started anticipating the wall. He could hear the crowd roaring, but since he was blind, he had no idea if they were cheering for him or someone else. Nineteen strokes, then 20. It felt like he needed one more. That's what the videotape in his head said. He made a 21st, huge stroke, glided with his arm outstretched, and touched the wall. He had timed it perfectly. When he ripped off his goggles and looked up at the scoreboard, it said "WR" – world record – next to his name. He'd won another gold."
Be Like Mike
Like Michael Phelps, your approach and habits you form may be the biggest influence you can have in achieving your financial goals even when you can't see where it is you are going. The power of achieving small financial wins over time will not only compound the interest we gain on our savings account, but will also compound our savings habit! Capitalize on small wins and turn them into your financial endstate.
The reason Dave Ramsey’s debt snowball is so effective is because of momentum. The momentum achieved in knocking out small amounts of debt first helps hone your focus and increases your drive and desire to tackle the entirety of your debt problem. Setting small financial goals and then achieving them will lead to the desire to reach even larger and seemingly more unattainable goals.
It’s not realistic to believe you can make drastic changes in your spending and savings habits overnight. With financial habits, knowledge is not usually the problem. The road to financial independence is not complicated, but it is difficult. The idea of spending less than you make and saving the difference is not very complex; it’s the execution that gets us every time. Despite what we know we need to do, it’s more often how we feel that drives our behavior. This is true whether we are preparing for a swimming race, or planning for our retirement. So how do we start making the necessary changes?
Watch the tape of your own life. Like Michael Phelps it helps to visualize what winning and achieving your savings goals will feel like. The power of visualization has been shown to dramatically increase performance. In fact research has revealed that mental practices are almost effective as true physical practice, and that doing both is more effective than either alone. Further studies show that thoughts produce the same mental instructions as actions, whereas mental imagery impacts many cognitive processes in the brain such as motor control, attention, perception, planning, and memory. So the brain is getting trained for actual performance during visualization. The result of mental practice is enhanced motivation, increased confidence, and the belief in the ability to succeed.
If you can’t picture yourself achieving a goal, chances are you probably won’t. The more vivid you can get with the visualization, the better it will work for you. Start thinking of your personal goals in life. Picture yourself achieving each one. Imagine what it will be like to pay off that last credit card, student loan, or overpriced car loan. Picture a life of financial independence where you can truly determine what it is you want to do with your time each day. These are all worthwhile goals, now imagine the joy in their attainment!
Build Your Financial Muscles
Develop the willpower needed to win your daily spending battle. Willpower is like a muscle, it gets tired as it is used but can be strengthened and conditioned over time. If you are like most people, you will begin the day with plenty of willpower, but as you are forced to make decisions throughout the day you will likely lose more and more of it. The development of routines helps you to positively respond when willpower is weak. Taking a play from Duhigg, developing specific rewards can help you cue good responses and help build your willpower habit loop.
Even investing small amounts of money over a long period of time takes an immense amount of willpower. The decision to forgo a pleasure in the present for a hypothetical need in the future is often very difficult to rationalize. To limit the inevitable internal conflict with saving money, don't make financial decisions at the end of the day when it is likely you are both physically and emotionally tired. Reserve those decisions for earlier in the day when you are fresh and your willpower is likely at peak readiness to avoid decision fatigue.
Just like working out, you need an accountability buddy. Reinforce success with those who will lift you up! Who we choose to surround ourselves with will often determine if we can achieve our goals. The Millionaires in Stanley’s book where quick to isolate themselves from the pressures of contemporary society and the need to impress others. Their desire to achieve financial success trumped their desire for social attainment. Find others who share in your goals. Recognize the cue and reward’s developed by others. If sport shopping is a form of entertainment, its best to find someone who you can enjoy cheaper alternative to spend time with.
Prepare for Failure
Make willpower a habit by preparing for inevitable failure. Insulate yourself from the desire to make dramatic changes in your saving and spending plan by choosing a certain behavior ahead of time, and then following that routine when an inflection point arrives. Duhigg uses an example from Starbucks to highlight how to reinforce your failure habit loop. Simply thinking about how we will respond to various situations help condition us to follow a routine in the face of conflict. Starbucks puts significant resources behind training their staff for developing proper cues for dealing with an angry customer. They train their employees with the appropriately named Latte Method.
L - Listen to the customer,
A - Acknowledge their complaint,
T - Take action by solving the problem,
T - Thank them, and then
E - Explain why the problem occurred,
Latte or not, a written plan, especially one that has instructions on how to handle a moment of weakness (when temptation is strongest) increases the odds of success. Your investment policy statement (IPS) is one such tool. Your IPS must account for how you plan to respond to a severe market sell off, or if you will stay the course even when it seems like there is always someone making more money along the way.
Stanley’s Millionaires developed an investment strategy early in their career and managed to weather their own fiscal storms. The most important part isn’t so much what their specific investment strategy was, but rather, the fact they could maintain it over a long period of time. It’s important you develop an investment policy you can live with. It doesn’t have to be complicated. Investment policy is simply just another way to describe financial goal setting.
Goal setting for how to save and invest your money and what you will do when things go awry. Because much of the investment returns are predicated on our own actions rather than our asset allocation, planning for failure is just as critical as planning for success. By taking a tip from Starbucks and choosing a behavior ahead of time we can understand the cues and rewards which will likely drive your action. By following the agreed upon preset routine you can counteract the likely response to fear and greed that inevitably affects every investor.
Change Your Financial Habits
Build healthy habits that support your financial goals. Find the keystone habit that will cause other habits to follow. It doesn't have to be big, but it must feel like a positive change. Identify the cues, routines, and rewards that are causing you to make poor decisions along the way. Capitalize on small wins over a prolonged period of time. Visualize the outcome you are looking for and what "winning" feels like. Build your financial muscles by increasing your willpower through repetition. Make financial decisions when your willpower is at its peak and only when you have to. Plan for failure and know how to counteract the emotions of fear and greed.