If we’re about to be hit by a car, our instinct is to jump out of the way.
As it happens, that’s also the smart thing to do. This would not be the best moment to stop and ponder whether we’re overreacting.
But while our instinctive reactions are often correct, especially when faced with physical danger, they can lead us badly astray when managing money. The problem: Our brains, hardwired to help our hunter-gatherer ancestors survive, are a bad fit for modern financial markets. The good news: With a little effort, we can squash our worst instincts—and make the right financial choices.
The brain functions in two parts. There’s the reflexive “blink” portion, which academics sometimes refer to as System 1. It makes snap decisions at lightning speed, often without us even being conscious that a choice has been made. System 1 effortlessly steers us toward rewards and away from risk, thereby helping us to survive.
When System 1 hits a problem it can’t solve, System 2 kicks in. This is the more ponderous, reflective part of our brain. Daniel Kahneman, winner of the Nobel Memorial Prize in Economics, refers to System 1 as “fast thinking” and System 2 as “slow thinking,” hence the title of his 2011 bestselling book, “Thinking, Fast and Slow.”
Even if we engage System 2 and think hard about a problem, success isn’t guaranteed: There remains a decent chance we’ll come up with the wrong answer. Still, if it’s a financial issue, pausing and thinking is far more likely to help than hurt, because our instinctive reactions are often so damaging.
When should we give System 2 a chance to weigh in? Here are eight classic financial mistakes:
Short-termism. A Wall Street strategist lowers her year-end price target for the Standard & Poor’s 500-stock index. Spooked by the idea of losing money, we’re tempted to cut our retirement portfolio’s stock allocation. But why would we let somebody’s short-term market outlook—which will be wrong half the time—influence our long-term investment strategy? It makes no sense, something we’ll likely realize if we take a step back and ponder the issue.
Availability bias. Our neighbor tells us that Snap, the company behind Snapchat, will be “bigger than Facebook.” It’s an attention-grabbing prospect, because it’s so easy to recall Facebook’s explosive growth. But before we load up on Snap’s shares, we should ask a host of questions. What special insight does our neighbor have that isn’t already reflected in Snap’s share price? What about all the other companies that are also trying to be “bigger than Facebook”? What about the competition from Facebook itself?
Muddled math. The Dow Jones Industrial Average dives 100 points and we’re immediately on high alert. Is this the beginning of a major market decline? It sounds like a large drop—and the TV talking heads sure seem excited—but 100 points today is equal to less than 0.5%.
Telling tales. We read about a money manager who visits hundreds of companies every year. We’re immediately impressed, assuming all that hard work must mean better results, and we’re tempted to buy his fund. But on second thought, we realize that Wall Street is full of hardworking money managers—and yet the vast majority trail the market averages.
Home bias. We are most comfortable with things we’re familiar with. That’s why we are happy to buy the big blue chip companies in the S&P 500, but we shy away from purchasing smaller U.S. companies and we’re even more averse to investing overseas, especially in emerging stock markets. For foreigners, of course, it’s the other way around: They are more familiar with their local companies and likely less comfortable owning U.S. stocks. So who’s right—or are we both mistaken?
Spotting patterns. Shares of Amazon, Apple and Facebook have soared in 2017, reminding us of the tech stock bull market of the late 1990s—and we wonder whether history is repeating itself. Pattern recognition was a crucial skill for our hunter-gatherer ancestors, allowing them to figure out where to find food and when the seasons were changing. We’re still excellent at pattern recognition, but the patterns we think we see in the financial markets are often meaningless.
Confirmation bias. We’re nervous about the economy and we latch onto information that confirms what we already believe, while ignoring opposing points of view. It’s like folks who get their political news exclusively from Fox News or exclusively from MSNBC. It feels good when others agree with us. But what if we’ve got it wrong?
Following the crowd. We hear “everybody” is buying bitcoins. We immediately sense we’re missing out and that we, too, should be buying. Problem is, while popularity is often the hallmark of a good movie or a good restaurant, it can be a red flag when investing. All that buying may have driven an investment’s price sharply higher—and that’ll mean lower future returns.
What if we chew over a decision and we still believe our initial reaction is the correct one? We may indeed be right. But why take chances? If it’s a significant financial decision, we should talk it over with our spouse, a friend, a colleague or preferably our financial advisor—and get their opinion.