How to Make Better Financial Decisions: Part 2

How to Make Better Financial Decisions: Part 2

May 22, 2024

financial decision-making part 2

How to Make Better Financial Decisions: Part 2

May 22, 2024

How WYSIATI and Recency Bias Impact Decisions

Daniel Kahneman passed away earlier this year. The professor of psychology won a Nobel Prize in economics for a lifetime of research on how humans make decisions, good and bad. I strongly recommend his book Thinking, Fast and Slow.

We are writing a series on his key findings to help you make better decisions. Last week’s post provides an overview of Kahneman’s research.

 

Daniel Kahneman's research reveals that humans often fall prey to cognitive biases, leading us to make hasty and sometimes detrimental decisions. This week, we're shining a light on these biases, particularly those that hinder us from adopting a long-term perspective. By applying them to financial planning, we aim to raise awareness and help you navigate these potential pitfalls.


What You See Is All There Is, or WYSIATI

This is our tendency to consider known knowns but to ignore known unknowns – factors that we acknowledge but for which we lack information. Examples:

  • When a crisis hits, and stock prices collapse, we see that impact on our net worth. We read the dire news and have a palpable understanding of what is happening today. We know that somehow and in some way, the crisis will pass. But we don't know how. So, we ignore the future – and too often, we sell investments at a low.
  • We'll do a lot to avoid tax today, but we're reluctant to save future taxes. That's a key reason investors have too little money saved in Roth IRAs, the most powerful investment account you can own. A Roth will save you tax money in 10, 20, 30 years or more. But it's impossible to calculate precisely how much. So, too often, we ignore future savings.
  • Most people claim Social Security too early, locking in a lower lifetime benefit. They can see what they will get today and know that if they wait, they will get more. Many retirees understand that if they live longer, locking in this lower benefit may create financial problems in their 80s and 90s. But it's impossible to determine how bad the situation will be, and no one knows how long they will live. So, it's easier to ignore the unknown.

Recency Bias

We tend to weigh recent events more than events farther back in time. Recent events are easier to remember and seem more relevant. In investing, recency bias is particularly dangerous. People tend to buy stocks or mutual funds that have done well over the past few years and shun investments that have done poorly. This tendency to overpay will likely lead to disappointing returns.

This difficulty envisioning the future also explains why many Americans fail to save enough for retirement.

Next week, we will discuss shortcuts we often take or biases we develop, which can lead to bad financial decisions.

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