How to Make Better Financial Decisions: Part 5

How to Make Better Financial Decisions: Part 5

June 13, 2024

financial decision-making part 5

How to Make Better Financial Decisions: Part 5

June 13, 2024

Strategies for Better Financial Decisions: A Six-Point Plan

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.

In Parts 1 through 4 of our series, we’ve examined insights revealed in Daniel Kahneman’s research. Read each post to gain a deeper understanding of the factors that impact your decision-making process, with a particular focus on your financial life.

In our final installment, we illustrate the most common decision-making mistakes and suggest a strategy for avoiding them.

 

So far in this series, we’ve discussed multiple decision-making biases and shortcuts that can damage your finances.

What You See Is All There Is (WYSIATI). This is our tendency to ignore future events even though we know they are likely to happen and to look only at our current situation.

Recency bias. In trying to predict the future, we assume the very recent past is more representative than what happened 5, 10 or 20 years ago – even when there is a lot more data available by examining a longer period.

Loss aversion. We overweight financial loss relative to financial gain, which biases us to take less risk than we could accept, limiting our financial resources.

Sunken cost fallacy. If we have invested in something, it’s particularly hard to give it up – even when we probably should.

Endowment effect. We over-weight the value of what we own, keeping us from making trades that may be in our best interests.

Anchoring. Our first exposure to something has a large influence on our expectations for the future. This explains why a dealer selling you a car starts a negotiation with a high price. In investing: we focus on the price we paid for an investment. Except for tax, the cost is irrelevant.

 

Here are a few more biases and shortcuts we have not discussed but which can be equally damaging.

Halo effect. If we have a positive view of someone or something, we’ll give him or her more than the benefit of the doubt. The result: we may agree to something we shouldn’t. Just because your financial advisor has done a good job for you in the past, that doesn’t mean you can take your eye off what they’re doing now.

Illusion of understanding. We overestimate our ability to predict the future. Don’t assume you, or an expert, can predict the future. A well-known example: the authors of Good to Great and In Search of Excellence, both wildly popular business books at the time, analyzed highly successful companies and provided convincing reasons why these companies were well above average and would continue to be. Yet, after the books were published, the companies they profiled under-performed their peers. Many people can make up stories to explain the past with an eye on predicting the future. Success in forecasting is rare.

Intuition over formulas. We often assume we have good hunches. A better way to make decisions is to use a well-constructed formula and remove personal biases and emotions. The adoption of the Apgar score, to assess a newborn’s health based on observable facts of a newborn’s condition, was a game-changer in saving lives, compared to relying on a doctor’s intuition, however well-intentioned. In financial planning: agree to a savings plan, or a target stock ratio, and stick to it. Don’t use your gut to change your plan on the fly.

Kahneman's research covers so much more. If you have read his book and want more, another fantastic read is Nudge by Thaler and Sunstein.
 

Making Better Decisions

So, how do you make better decisions in the face of our all-too-human tendency to let our biases overwhelm our ability to think clearly or in the face of our tendency to let what Kahneman called System 1—the part of our brain that makes split-second decisions—overwhelm System 2—the part of our brain that thinks more carefully but requires effort to engage?

Implement a 6-point strategy.

  1. Start with a long-term plan. If it’s carefully constructed, it will address many of the issues you can face. You just have to stick to it. Examples: I am going to save 10% of my income annually for the rest of my working life. I am going to take a lot of investing risk when I am young and gradually reduce that risk when I am 60. I am never going to buy extended warranties because I can afford the occasional repair. I am going to donate 5% of my income annually until I retire. I am going to give an inflation-adjusted $10,000 to each of my children every year to reduce my taxable estate.
  1. When facing any important decision, slow down. Even if you have a plan, it’s easy to ignore it and make one-off decisions you may later regret. If you slow down, you’ll take emotions out of your decision process.
  1. Adopt a repeatable technique to think through important decisions. That may mean writing down pros and cons or agreeing you will wait a few days to decide. It may mean spending a defined amount of time to study any important issue.
  1. Recognize that outside actors may be influencing you with their own agendas. Be skeptical. An annuity salesperson will likely exaggerate the risk of the stock market to create fear, making an annuity look better. Your CPA may suggest creating a tax break now instead of recommending you contribute to a Roth IRA, which only creates a tax break in decades. The tax break today, even if it’s smaller, will make the CPA look smarter. Your financial advisor may suggest taking Social Security sooner than you should, which will mean you need to withdraw less from your investment account – keeping their fee higher.
  1. Consider getting help from a trusted third party, whether a family member, friend, or impartial advisor. They can avoid the emotions and biases you face because it’s not their money.
  1. Sometime after your decision, look back and hold yourself accountable. We all make mistakes. Learn from them.

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This article is not intended to provide tax, legal, accounting, financial, or professional advice. Readers should seek advice from qualified professionals who can review their specific circumstances. Old Peak Finance endeavors to provide information that is accurate and current. However, we cannot guarantee that this information has not been outdated or otherwise rendered incorrect by new research, legislation, or other changes. Old Peak Finance has no liability or responsibility to any individual or entity with respect to losses or damages caused or alleged to be caused, directly or indirectly, by the information contained on this website.

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