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How Can You Make Healthier Financial Decisions in the Future?

14

Behavioral finance has concluded that we rarely learn from our money mistakes.

Our ability to make sound financial choices requires us to remember and learn from past experiences. Yet when it comes to money, our memories are brief and flawed. In A Short History of Financial Euphoria, economist John Kenneth Galbraith observed that the “extreme brevity” of financial memory, coupled with relative ignorance of economic history, leads us to repeat the same financial mistakes time and again. As a result, tremendous wealth is forfeited. These tendencies are exacerbated by several cognitive decision-making shortcuts, or biases, documented in behavioral finance literature.

Self-Confirmation Bias: We recall our investment successes much more vividly than our mistakes, yet downplay our contributions to negative investment outcomes.

Saliency: The more recent and dramatic an event, the greater the perceived probability of its recurrence; regardless of the actual probability. After a recession we may ignore signals that a recovery is underway, believing that another drop is imminent. In fact, periods directly following past crises have provided opportunities – in the form of market recovery as well as fiscal stimulus. For example, most of us were so worn out by the Dow’s drop to 6,500 in 2009 that we had no appetite to purchase more shares when the market was at an historic low; with this severe market dive in our recent past, we overestimated the likelihood that it would happen again, and soon.

Hindsight Bias: Events in the past seem more understandable and predictable to us. For example, today many investors insist that they had reservations about the stock market in late 2007. This “I saw it coming” phenomenon encourages overconfidence in our ability to forecast economic events and has significant consequences because it distorts our perception of risk.

Persistence: The predisposition to perceive patterns in situations that are random and unpredictable. We may move 100% of our 401(k) into the fund that outperformed last year, even though there is no logical reason to believe that something will keep happening simply because it has been happening.

Myopic Loss Aversion: According to a study by Benartzi and Thaler (1999), people have a strong tendency to focus inordinately on the immediate present and struggle to readily concentrate on the distant future. Managing your portfolio over a long period of time (ten to thirty years) requires a tolerance of the inevitable short-term (one to three years) fluctuations in the markets. As a result, many people obsess over short-term changes, react negatively to short-term losses, and succumb to reactionary investment strategies that diminish their long-term results. These investors typically buy high and sell low in order to put an end to the discomfort of short-term losses, then wait on the sidelines for the market to recover before they feel confident enough to participate again.

How can we use these insights from behavioral economics to make healthier financial decisions in the future?

Be Aware of Your Own Biases
Our brains are hard-wired to be biased; it is part of what makes us human. Biases are cognitive “shortcuts” that have significant value to us in many situations. Unfortunately, they also have the ability to sabotage our investment goals. Developing an awareness of the ways that biases affect your financial decisions is the first step to becoming a more objective, rational investor.

Don’t Lose Sight of Your Goals and Your Strategies to Achieve Them
Following a well-defined plan can help you significantly improve your financial success relative to your track record. Before we recommend an asset allocation strategy or select specific investments for our clients, we counsel with them to identify what life events they are investing for, when those events will occur, and their tolerance for risk and volatility. Only then can we establish a personal investment policy – an investment “compass” or blueprint – tailored to help each client stay on course. Defining goals, parameters, and even restrictions for your investment portfolio keeps them front-of-mind during periods of market volatility and provides guidance during times when you may feel tempted to make short-term decisions that interfere with your long-term goals.

Regular Communication and Meetings
Communication is crucial to the well-being of any relationship, and your relationship with your money is no exception. We can better serve you when we are able to talk and meet with you on a regular basis. Frequent communication about your investment strategy, and why it makes sense for your goals and circumstances, can help you feel confident when the market’s behavior makes you uncomfortable. It’s important to have a source of objectivity and support for better investment decisions. Time and again we serve as a sounding board to help our clients realize that the best response to market noise is almost always not to react at all.

We give history predictive powers in ways that don’t help us, and we ignore history when it can be reassuring and provide a check against impulse. If the past really can predict the future, then we know that those who understand that money is inherently emotional make healthier financial decisions.

Please do not hesitate to call me if you would like to discuss this article or anything else.

Laura Lyons CFP
(865) 342-4471
llyons@trustmeridian.com

Reading List:

If you are interested in reading more about the psychology of investing, consider these titles:

“Predictably Irrational: The Hidden Forces That Shape Our Decisions,” by Dan Ariely
“The Psychology of Money,” by Jim Ware
“Think Twice: Harnessing the Power of Counterintuition,” by Michael J. Maboussin
“Why Smart People Make Big Money Mistakes and How to Correct Them: Lessons from the Life-Changing Science of Behavioral Economics,” by Gary Belsky
“Your Money and Your Brain,” by Jason Zweig

Meet the Author

Laura K. Lyons, CFP®
Financial Planner

A Certified Financial Planner practitioner, Laura is the newest member of Meridian’s team. She works closely with Meridian’s clients and is here to help you take the right steps to achieve your financial goals. As a part of this process, she collaborates with your tax professionals, estate planning attorneys, and other trusted advisers.  By partnering with a CFP® to coordinate these important aspects of your financial life, you can focus on your passions and interests with the peace of mind that you are making the best financial decisions for you and your family.