Are we
hard-wired to make bad decisions? The answer to that is yes, according to behavioral psychologists and economists
who study this field. And I agree; what they say rings true.
There
has been at least one session on
behavioral finance at every conference I have attended over the past several
years. The
purpose of this article is to share some of what I have heard and read from
books like
Thinking Fast and Slow by Nobel-prize winning psychologist Daniel Kahneman,
Predictably Irrational by Daniel Ariely, and Decisive by Dan
Heath. By the way, I would recommend all
three for further reading if this interests you. Decisive is the
easiest read, while the Kahneman book gets pretty deep. And why are they all named “Dan”?
To say
that I have perfected my decision-making would be a wild overstatement. Even the most diligent among us is still
naturally wired to get it wrong sometimes, but knowing our bad habits is a good
place to start the lifelong process of consciously attempting to make better
choices.
I
don't have the space to delve into the many facets of this broad field, but I
will hit two of the more prevalent pitfalls.
Perhaps in future issues of “Review & Outlook” I can dig deeper.
Anchoring:
This
is the term used to describe how getting a number (or some other bit of
information) stuck in your brain impedes the decision-making process. An
example I see often, is the top price your home was ever worth. Everyone
has that permanently tattooed somewhere in their skull (or so it seems from
discussions I have had with otherwise rational people). I hear folks say,
"I really don't want to sell the house for X. We are losing money -
just a few years ago it was worth Y". OK, but….the fair market value
of something is what a willing buyer will pay a willing seller. Just because 7 years ago somebody was willing
to overpay your neighbor for their home does not mean you are "losing
money".
If you
really want to sell your home, you may need to remove that "anchored"
number from your brain. Otherwise, it might keep you from accepting a
fair offer, or at a minimum, make you feel bad about a reasonable financial
transaction. Let it go....and you are likely to make better financial
decisions. I use the home example to make a point, but think about other
things that are anchors, and be aware of how they can weigh down your decision
making.
Overconfidence:
This
might be villain #1 in your battle for good decisions. Study after study shows
that we
believe we know more than we actually do.
We believe the future is much more certain than it actually is. That overconfidence can cause us to get lazy
with our analysis and decision
making. We will seek out affirming
opinions and ignore disagreeable ones.
This works against sound decisions, likely causing you to miss the full
range of potential outcomes. You may fail to honestly assess the likelihood of
success or failure. It creates a blind
spot.
One
process to deal with this is to invite disagreement. I know it doesn’t sound
like fun, but for important decisions find someone who will play “devil’s
advocate” and talk through your decision with them. At a minimum, ask yourself, “Where am I
likely to be wrong in my
thinking about this?”
To be
fair, pros or “experts” are likely to fall prey to this hubris as well. We can sound awfully sure of ourselves when
we need to. So let’s agree to help each
other with this “overconfidence” problem.
First, we promise not to just be “yes-people” to your financial
decisions; we may challenge you to think about other alternatives, or be more
realistic about the prospect of success or failure of a particular path. In exchange, you agree to challenge us when
something isn’t clear, or doesn’t ring true to you. We welcome open and honest
discussion. The evidence is strong that
it leads to better decisions and better outcomes. Isn’t that what we’re all shooting for?