From the Outside Looking In (part 3)

“If I had a million dollars…” is a refrain often spoken and contemplated. From song lyrics to day dreams, we spend time fantasizing about what we would do with such a large sum of money. For many, accumulating a million dollars seems unattainable, but in reality, it can be achieved. The keys are: utilizing a predetermined and dedicated savings/investment program, sticking with good financial management, and making smart choices.

Of the three items listed above, the piece that is often ignored is “making smart choices.” In fact, what we think are smart choices may be the exact opposite, they could be emotional reactions to something going on in our world at the time. This paper, part three of a series, uses the tenets of behavioral finance* to examine how and why our actions often impede smart financial decision making.

From the Outside Looking In (part 2)

“The investor’s chief problem—and even his worst enemy—is likely to be himself.” Why is this so? This paper, part two of a series, uses the tenets of behavioral finance* to examine how and why our actions often impede good financial decision making.

In part one, (Behavioral Finance Part I) we introduced the topic of behavioral finance and how our biases can prevent us from making the best financial decisions. We discussed three common and powerful biases: loss aversion, conservatism, and hindsight. In part two, we will discuss three more biases and show how they can interfere with an important financial objective— investing retirement funds for growth in the face of risk and uncertainty. In addition, we will provide suggestions for overcoming these tendencies. The goal: to help you become a better informed and successful investor.

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.