Don’t Let Your Mind Lead You Astray When Investing

It’s no big secret that humans are prone to financial mistakes. If we were the perfectly rational creatures depicted in economics textbooks, then our world – and our checkbooks – would be tidier and more orderly.

But we can take some steps to minimize falling into common behavioral traps that tend to trip us up. The first step is to recognize them.

Predictable Errors

Many recent publications have discussed something called “behavioral finance.” This studies how the human brain works when it makes financial choices.

Our brains face a deluge of information. The volume of data has grown much faster than our brains have evolved to capably deal with it. So what do we do? We create shortcuts – mental tricks — that help us cut through the sea of information and make the choices, ranging from what brand of milk to buy at the grocery store to what stock funds to add to our retirement portfolio. These shortcuts are similar from person to person. We may all be different, but we manage to get it wrong in the same way.

Pictures Speak Louder Than Words (Or Numbers)

Some data vividly imprints itself in our mind for years, while other data causes our eyes to glaze over. When we need to make a decision, we instinctively reach out for the memories – the data – that we can most quickly recall. We don’t reach for the best data; we reach for the fastest and easiest. In behavioral finance this is called “availability bias.”

Here’s an example: Imagine that you’re picking a large-cap growth fund for your portfolio. There are more than 3,000 large-cap growth mutual funds from which to choose, and there’s a deluge of comparative information you would need to sift through to make this decision.

But wait! Just last night you were watching CNBC and Joe Smith, manager of the Red Hot Growth Fund and a charming speaker, was talking with one of the show’s hosts about how his fund was up 10% in the last three weeks. That image comes vividly to mind.

Your brain has found a shortcut: a single data point that seems to make a good argument about why the Red Hot Growth Fund should be a good choice for the portfolio.

Remember, your brain is busy. It’s inefficient to dwell over the relative merits of 3,000 funds if we can take a shortcut instead.

Shortcuts to Nowhere

Of course, you probably see that the shortcut in the previous example was a bad idea. One limited data point, like the three weeks of performance for a solitary fund, says nothing about whether it will be a good addition to your portfolio. You don’t even know if 10% was a good return for that time period – maybe the overall market was up 15% in the same period. Or maybe the Red Hot Growth Fund had tanked for the last 12 months and was slightly rebounding from a low starting point.

The point is that without lots of other data – such as performance results for comparable funds and broader market context — you have no basis for making a sound decision. Yet we fall into this behavioral trap time and time again.

We can’t expect our brains to become quantitative powerhouses that can crunch massive amounts of data in seconds to arrive at rational decisions. That’s not going to happen. We can, however, use powerful tools to help us make these decisions.

The amount of digital information in the world is far greater than our brains can handle, and its growing more every day. The best way to succeed is to arm ourselves with the tools that can help get the job done.

Can you think of a behavioral finance trap you’ve ever fallen into? Tell us what you think.