Why smart people make bad financial decisions

The idea of exploring how people make decisions, and specifically financial decisions, has always been of particular interest to me.

Earlier in my career, I read almost everything available on the fundamental side of finance and investing.

I started with easy to digest pieces such as Peter Lynch's "One Up on Wall Street" and eventually went deeper into works like Seth Klarman's "Margin of Safety" on deep value investing.

All this reading, along with my MBA and CFA studies, helped me build a strong foundation.

But I always felt like something was missing.

Sure, the markets are efficient and investors as a whole are rational. But how come almost every year we see rapid market declines that catch so many people off guard?

In most cases, the information has always been there. The markets just decide to ignore it for one reason or the other.

What really helped me close this gap is Daniel Kahneman's remarkable work called "Thinking, Fast and Slow."

Kahneman goes really deep into how the systems of thinking and decision making actually work.

I use the lessons I learned from it in my professional and even personal life and wanted to share some of it with you.

I don't necessarily suggest that you go and read the book though. It took me several weeks to finish it and it wasn't an easy one to digest. So it's not a casual weekend read like some other books on personal finance by well known authors.

But no worries here. Just like all of our newsletters, it will be in plain English and easy to understand!

Here are the basics

System 1 is your fast, automatic and intuitive thinking (i.e. Fast Thinker). It runs in the background all the time and without any conscious effort.

This is what helps you recognize a familiar face or answer 2+2 without hesitation.

System 2 is your slow, deliberate and analytical thinking (i.e. Slow Thinker). It takes real focus and mental energy to engage.

Working through a complex task such as reading a legal document or thinking carefully about a big financial decision are all System 2 activities.

Here is the twist that I believe most people miss.

We tend to believe System 2 is in charge of the important decisions in our life.

But in reality, System 1 makes most of them without us even realizing it.

System 2 often just rationalizes what System 1 has already decided.

Now that we’ve covered the basics, here are some of the behavioral traps that the Fast Thinker often falls into.

Loss Aversion

Let's start with an easy one which I'm sure many, if not most of you, will be able to associate with.

Kahneman's research showed that the pain of losing $100 feels twice as intense as the joy of gaining $100.

Because our brains hate loss, the Fast Thinker in our mind urges us to hold onto cash or avoid investing when markets are turbulent.

It feels like a safe decision at the time but over time inflation silently erodes that "safe" cash you have in your proverbial mattress.

Anchoring

When Fast Thinker doesn't know what something is worth, it grabs the first number it sees and locks onto it.

If you buy a stock at $50 and it drops to $30, Fast Thinker fixates on that $50 baseline, refusing to sell because you want to break even.

Fast Thinker disregards the facts about the investment even when they clearly point out that the recovery is unlikely.

Have you ever found yourself anchoring on something?

Framing Effect

Would you make an investment with a 90% chance of success?

Would you make one with a 10% risk of failure?

Have you noticed that these two are essentially identical decisions?

But Fast Thinker reacts to the word "risk" with anxiety and "success" with optimism.

How financial news frames a headline heavily influences how we feel, regardless of the underlying facts.

And this is why I believe that financial news is good to aggregate data but less than ideal for actual investment portfolio decision making…

The Sunk Cost Fallacy

Ever kept paying for an unused subscription, or held onto a losing investment simply because you've "already put so much into it"?

Fast Thinker hates admitting a mistake.

So it keeps pouring resources into a bad situation just to avoid recognizing the initial loss.

Have you ever put more funds into an investment that you originally purchased several years ago and that has a loss in it?

Availability

If you recently read intense news stories about a potential market crash or a political decision, your brain treats a market decline as imminent and unavoidable.

We end up over preparing for what we see as inevitable.

Meanwhile, we ignore the long term trends in the markets.

This one is of particular importance and specifically for our clients in the DC area.

We live in an area that is particularly sensitive to political news.

Please, be very careful if you ever decide to make investment or portfolio rebalancing decisions based on how you feel about the current political state of the country.

I think this is a sensitive topic so I will be as gentle as possible. I will simply say that many studies show that politics is much less impactful on investment returns in the long run than most retail investors believe.

What does this mean for you?

Most of the biggest financial mistakes I’ve seen weren't caused by bad information.

They were caused by Fast Thinker making a decision that Slow Thinker never had a chance to review.

The good news is you don't need to become a behavioral scientist to protect yourself.

You just need to slow down before any important financial decision.

Ask yourself how you actually arrived at your conclusion. Was it driven by fear, recent news or a specific number stuck in your head?

Consider writing it down. This one habit actually helped me make much better decision on numerous occasions.

Keep in mind that the decisions you make under stress are rarely the ones you would make with a clear head.

And when it comes to your financial life, that difference can be everything.

Reading Kahneman's work changed how I approach every important decision.

I hope some of these ideas do the same for you!