How to Make Better Financial Decisions: Part 4

How to Make Better Financial Decisions: Part 4

June 6, 2024

financial decision-making part 4

How to Make Better Financial Decisions: Part 4

June 6, 2024

How a Long-Term Mindset Impacts Investing Strategy

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.

Previous posts in this series provided an overview of Kahneman’s research, exposed mistakes that prevent us from taking a long-term view when making decisions, and highlighted shortcuts and biases that can lead to bad financial decisions.

 

Today, based on Danial Kahneman’s research, we’re providing a specific example of how to fight against one of the trickiest biases: loss aversion.

Research has demonstrated that the average person requires $250 in winnings to accept a 50/50 bet when the loss is $100.

In the real world, it’s hard to find a 50/50 bet where the payoff if you win is 2.5 times the loss. As a result, most people shun risk – much more than they should. That means they are forfeiting significant earnings potential. Who benefits from your risk aversion? Insurance companies and other institutions that sell overpriced products that guarantee safety.

There is a better approach.

What if, instead of one 50/50 bet, you were offered 100 50/50 bets? Surely, you would accept a payoff far less than $250. That’s because when the bet is repeated 100 times, you are far more confident you can predict the outcome within a narrow range. Your risk has diminished. Importantly, this is the primary reason an insurance company will take risks that you won’t. They have tens of thousands of clients or more. They will lose some bets, but they win on average if they build even a small cushion.

Let’s apply this approach to investing. Imagine your theoretically appropriate mix of stocks and bonds is 60% stock and 40% bonds. You know that, over a lifetime, you will almost certainly do better than if you were in a mix of 40% stock and 60% bonds. But at any one moment, 60% stock feels risky. So, when the market falls, you are tempted to sell.

The solution: treat every quarterly investment report you receive as one of 100 you will receive over 25 years. Make a plan at the start of the 25-year period to keep to your 60/40 mix throughout. Rebalance your investments every quarter. Recognize that every statement marks a small step on a long path. A good quarter doesn’t change your plan, nor does a bad quarter – in the same way that neither an individual result of a coin flip result - heads or tails - changes the likely long-term result.

Taking a long-term view requires discipline and a plan. But the rewards are clear.

In the final installment of our series, we’ll do two things:

  1. Provide a few final illustrations of the most common decision-making mistakes we make
  2. Outline a broader strategy on how to avoid mistakes

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