From the Outside Looking In

Have you ever noticed how easy it is to know when someone else is making a bad decision—a friend is impulsively quitting her job; a family member is buying a house that seems too expensive; your brother has no retirement account? We find it easier to assess someone else’s choices because we all have two views of the world: an outside view and an inside view. When you think about someone else’s situation you are able to consider it from the outside, using the rational side of your mind. But when it’s a decision affecting your own life, the emotional side often takes over. So why is it seemingly impossible to take emotions out of making a decision about our finances?

Part one in this series examines how and why we act as we do. We'll use the tenets of behavioral finance* to examine our natural vulnerabilities and tendencies that so often impede good financial decision making. We'll explain some of the common and most powerful biases, help you to assess which biases you're the most prone to, and provide tips for overcoming those portfolio-wrecking tendencies. The goal: help you become a better informed and successful investor. But first, some background information.

How the Brain Works

Our brains enable us to process information and make decisions. The brain is divided into sections that control specific functions. The amygdala is action-oriented; it controls our “fight or flight” instinct and emotions such as anger and fear. In his book, The Little Book of Behavioral Investing, James Montier likens this part of the brain to the Dr. McCoy character from the Star Trek series.1 It operates automatically and quickly. You don’t control it. It just happens. It’s an automatic system that generates impressions, intuitions, and feelings.