By: Laura Walton AFC®
We are told that in order to learn from experience we need frequent practice and immediate feedback. How does this play out in money decisions?
Richard Thaler’s book Misbehaving gives lots of everyday examples of how we humans make illogical decisions. Traditional economists assume we are logical thinkers and have all the relevant facts. Behavioral economists like Thaler think otherwise.
He illustrates his point by making a list of products ranging from those we buy frequently to those we seldom buy. The list might look like this:
groceries->shoes->a watch->a car->a home->a career->a mate
He argues that we buy the items on the left end of the list more frequently and, therefore, learn to make good decisions through experience. The products towards the right end we buy (or choose) only a few times in our lifetime, not often enough to have learned from experience.
He singles out retirement planning as something we do only once which makes it a challenge for us to get it right – we have no practice, no experience.
His conclusion? “As the stakes go up, decision-making quality is likely to go down.”
Add in a few of what economists call biases – things that skew our thinking – and it’s easy to make a poor decision. For example:
Status quo bias – when we prefer things to stay the same by doing nothing or by sticking with a decision made previously. Example – being reluctant to sell a poorly performing investment; instead, ask yourself if you would make that investment today – if not, then sell.
Confirmation bias – when we believe our information is correct and only look for evidence that confirms our thinking. Example – not seeking professional advice or selectively listening to only the advice that supports your thinking.
Optimism bias – the tendency to be overly-optimistic, overestimating favorable and pleasing outcomes. Example – the “Pollyanna” effect, thinking that you don’t need to plan for retirement because you make a decent wage and don’t spend too much so you assume ‘everything will be okay’.
Hindsight bias – the tendency to see past events as having been predictable. Example – the Monday morning quarterback who says they saw a particular financial event coming when we know markets are inherently unpredictable.
Outcome bias – the tendency to judge a decision by its eventual outcome instead of based on the quality of the decision at the time it was made. Example – a poor outcome doesn’t necessarily mean a poor decision; your decision may have been the best course of action given the facts at the time.
It’s a mine field! The takeaway? If you’re making decisions about something you’ll do only a few times in your life, recognize your biases and get good advice!