My brain made me do it: How to avoid bad investment decisions.

So far during 2011, the Dow Jones Industrial Average has had moves of 100 points or more on 97 trading days.  That’s 23 more than during all of 2010 and the year isn’t even over yet.  With so much volatility and uncertainty, it would be easy to panic and make decisions you’ll later regret.  Unfortunately, your mind isn’t always wired to help.  In fact, it can actively work against you.  Below are seven cognitive biases that could cause you to make bad investment or retirement planning decisions, as well as suggestions for overcoming them.

Attention bias

This is the tendency for emotionally dominant stimuli to monopolize our attention.  CNBC, I’m looking at you.  Spending too much time watching the ups and downs in the market is likely to fray your nerves and cause you to sell low and buy high.  Remember the words of Warren Buffett: “The market exists to serve you, not instruct you.”

Bandwagon effect

This one is pretty self explanatory and was the primary driver in such spectacular failures as the internet, telecommunication and housing bubbles.  When trades get completely one-sided (gold?), it’s time to ask yourself if you’re just buying or selling because that’s what everyone else is doing. 

Action bias

In times of stress or danger, it sometimes makes us feel better to act, even if it would be better for us to sit on our hands.  A great example I heard of this recently relates to soccer.  During a penalty kick the ball is kicked to the center of the net 30 percent of the time, but the goalie only stays put 6 percent of the time because he doesn’t want to look like he’s not trying.  Sometimes the best thing you can do is nothing.

Recency bias

This is our tendency to give more weight to recent events than past events.  The 2008 global financial meltdown is still pretty fresh in everyone’s mind.  Eager to avoid a repeat, many are ready to move to the sidelines at a moments notice.  Keep in mind, though, that during the lifetime of the baby-boomers, the S&P 500 has gone from about 17 to 1,250.  That’s 73 times higher now than when the first baby-boomer was born.  Don’t let the emotion of recent headlines completely overshadow the historical record. 

Hyperbolic discounting

This is our tendency for immediate gratification at the expense of the future.  In a nutshell, Current You doesn’t care much for Future You Current You wants to stop making 401(k) contributions and put the money under the mattress so he can sleep better at night.  Future You needs that money saved and invested so he can afford to retire.  If you want Future You to be happy, you need to convince Current You to make some decisions that are uncomfortable.

Negativity bias

This is our tendency to give greater weight to negative information over positive.  Yes, there are a lot of things wrong with the world, but there is a lot that is right.  Pick any vintage from the wine cellar of history and you’re likely to find some sort of man-made or natural disaster.  And yet, the economic and technological progress we’ve made over the last many decades is amazing.  Admittedly, it sometimes feels like a yo-yo, but if you step back you can see that the general progression has been up and to the right. 

Illusion of control

Finally, we arrive at our tendency to assume that we have more control over events than we actually do.  None of us can control the debt crisis in Europe, but we can control our personal debt.  We have little influence over Washington’s spending, but we can make sure our own budgets are in order.  Few of us have the ear of the Social Security commissioner, but all of us can make sure that our own retirement investments are allocated properly and that we have a logical distribution strategy.  In short, focus on those things you can control.

Will Rogers once said “It’s not what you don’t know that hurts you.  It’s what you know that isn’t so.”  The way our brains are wired, as well as the ups and downs in the markets during the last few years, have caused many to make regrettable decisions based on “what they know that isn’t so.”  Hopefully understanding your brain’s natural tendencies can help you make better long-term decisions that result in a secure, meaningful retirement.

Thanks for reading.  If you enjoyed this article, scan the “Related Posts” section below for others like it.

Joe

No comments yet.

Leave a Reply