“All you need is the plan, the road map, and the courage to press on to your destination.”
— Earl Nightingalea, American radio speaker & author
Heuristics are mental shortcuts, derived from previous experiences, that let us make decisions quickly and efficiently. They may have literally saved humankind from extinction. If our ancestors were in danger, heuristics let them quickly decide between fight, flight, or freeze. Pick the right option, and you live to fight another day.
Heuristic decision-making is still with us, although it doesn’t always result in optimal outcomes. These mental short cuts are simply not good for modern tasks that require rational thinking and analytical power. This includes long range financial planning.
Sometimes, investors may feel they are in danger and make quick decisions that are inappropriate. And, even those who slowly reflect on their situation may fall prey to cognitive biases that skew their thinking and lead to an irrational decision.
Behavioral finance is the study of the psychology of financial decision making, including heuristics and cognitive biases. In 2002, psychologist Daniel Kahneman, received the Nobel Memorial Prize in Economic Sciences for his research into human judgment and decision-making under uncertainty. In 2017, economist Richard Thaler received the Nobel Prize in Economic Sciences for establishing that people are “predictably irrational.”
Before the field of behavioral finance emerged, economists relied on the assumptions that humans are 100% rational, have perfect self-control, and are 100% focused on money as an incentive. Now, of course, modern research has proven that this is a flawed model because, in fact, humans are irrational.
When it comes to being occasionally irrational, we are really just “normal.” As investors, we are influenced by our biases, and we sometimes make cognitive errors that lead to poor decisions. So how can we be sure we don’t become our own worst enemy and jeopardize our financial security? How can we overcome emotions, self-deception, and the heuristic simplifications that trip us up?
There are two strategies we can employ. The first is to slow down your thinking and slow down your racing brain. Focus, trust your investing process, and be aware of what is happening to you both inside and out. If we don’t stop to reflect, we can have a reflex, knee-jerk reaction based on gut feelings and intuitions. This type of decision making is quick, effortless, and automatic, and generally it is our default option. However, relying on reflexive decision making makes us prone to cognitive biases and emotional influences like loss aversion (“Sell now, before I go broke!”), herding (“Buy now! Everybody is buying this stock.”), regret (“I’m never buying another stock.”), and overconfidence (“I’m going to get a second mortgage on my home and buy more stock.”)
The second strategy for overcoming behavioral finance biases is to prepare, plan, and devote oneself to an investing strategy. Know that markets are volatile in the short term, but over the long-run sticking to a strategy gives you the best chance to reach your financial goals. This is a reflective approach to investing, whereby you apply complex thinking and analytical power to move forward in a logical and methodical way. Preparing, planning ahead, and recognizing in advance that there will be days, weeks, months, years that the markets will be down helps you to focus and trust the process to get you where you want to go.
Preparing, planning, devoting, focusing, and trusting the process will help your decision making because the process helps you to engage in reflective decision making. Mindfulness, awareness, and thoughtful reflection during both down and up markets will lessen the probability of making irrational decisions at inappropriate times.