Understanding behavioral finance

March 10, 2017
Mike Palmer, CFP
Mike Palmer, CFP

A 3-step program to better investing

Navigating each day requires us to make thousands of decisions, and our brain's default setting is to ignore conflicting information. When doing so, we often overlook valuable information that completes the picture.

While mental shortcuts help in some facets of life, falling victim to confirmation bias in matters of personal finance can lead to subpar results.

Some of my physician clients came to me with portfolios they had managed themselves. When I analyze these portfolios and dig deeper about how investments were selected, I find confirmation bias is often at work. 

For example, many investors utilize Morningstar (a publication providing mutual fund research) when picking funds. “I only pick four- or five-star rated funds,” is a common refrain during initial meetings with prospective clients. 

However, when I ask if they did any research to determine correlations between Morningstar’s highly rated funds and superior performance, I get a quizzical look. (Hint: the most meaningful correlation between a fund’s future performance isn’t the number of stars; it’s cost).

Also, investors should not overlook negative stories about an investment in a sea of otherwise positive press. What’s the track record of the “experts” you are using? Finally, if working with a financial adviser, be sure to ask what process they use to overcome confirmation bias.

Doctors are especially prone to confirmation bias for the simple reason that most work in demanding environments under intense time pressures-not the optimal environment for contemplative decision-making. 

 

Financial decisions are often easy to enter but harder to exit, making the stakes involved with an error that much higher. 

Next: Avoiding bad financial decisions

 

Examine the other side of the trade

All transactions involve two parties-a buyer and a seller. It’s important to consider what information the other side of the trade might have that you don’t, especially in a situation where there’s limited market information. What’s the motivation of the other party? Consider whether you would do the deal if you were in their shoes. Remember, if it sounds too good to be true, it probably is.

Actively seek disconfirming informationa

One way to do this is to write down at least three reasons the investment might not perform as expected and try to put a probability on each. Research indicates merely writing this information triggers the area of the brain associated with deeper reasoning. Any technique that takes an opposing view helps to counter confirmation bias.

The saying “two heads are better than one” has merit

It’s helpful to have an unbiased friend or colleague vet your analysis. One famous psychologist uses an interesting twist on this idea by presenting his friends the opposing view of his intended course
of action to see if they endorse it, and if so, why. 

Navigating each day requires us to make thousands of decisions, and our brain’s default setting is to ignore conflicting information. When doing so, we often overlook valuable information that completes the picture. While mental shortcuts help in some facets of life, falling victim to confirmation bias in matters of personal finance can lead to subpar results.