Mental Missteps – 3 Questions Worth Re-examining

Several weeks ago we celebrated our son’s birth, and since then we’ve been lucky to get a few hours of uninterrupted sleep each night. I would find myself asking the same questions over and over… the very ones that behavioral economists warn you about when it comes to financial and investing decisions.

Question 1: Will this ever end?!

Usually at around 3am or when our 3 year-old daughter is in the midst of a tantrum, I ask this question. When your investment portfolio is down 3 months in a row, you might ask the same question.

We might know full well this will pass, but we are all subject to “recency bias” that causes us to place a disproportionate amount of weight on recent events.

Question 2: Will it be just as bad this time?

Our beliefs are strongly influenced by experience. After the first month with our baby, I was convinced this time would be just as difficult as it was with our daughter. The weak residential real estate market might make you think back to the last cycle or the one before that – will home prices come back like they have in the past?

Neuro-economists and behavioral finance academics suggest it actually does not matter whether you believe this time will be the same or different!

They explain that our memories are fragile, and we often misremember things to reinforce our beliefs. What’s more, if presented with new information, you will have a tendency to ignore anything that conflicts with your beliefs – this is called the “confirmation bias”.

Question 3: How are things – what should I do now?

Newborns cry… a lot. There is just something about the sound that demands our rapt attention and a course of action – whether it’s feeding, swaddling, diapering, etc.

The constantly updated performance of the financial markets is a bit like a baby screaming from your phone, laptop, TV or radio. New information draws our attention and instinct for action – to buy, sell, hold, rebalance, etc.

There are many things going on here, but in summary, the reward centers and fight-or-flight portions of our brains come into play and can push us to take inappropriate action or make mistakes in judgment.

How should we deal with these cognitive biases?

So what do experts suggest that I (and investors) do to better adapt to change and external stimuli? Simply recognize that we are subject to biases and short-cuts, and try to create reminders or firewalls to snap decisions. This could involve simply waiting to make a decision, consulting a trusted friend or advisor, or even recording your thoughts in a journal.