Why We Make Irrational Financial Decisions | Simple Steps for a Retirement Portfolio Course

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The brain is a machine that automatically processes information.
While this fast processing power enables us to make decisions, sometimes these decisions
are made so quickly that the brain bypasses logical decision-making.
In the behavioral economics book Nudge, Richard Thaler and Cass Sunstein explore how our brains
process information.
In the book, readers are presented with two tables and asked which one is narrower.
You might guess that the table on the left is narrower, but in fact, they're identical
in size.
Their different orientations trick your eyes into perceiving differences that aren't
there.
In the past, having vision highly attuned to differences may have had evolutionary benefits like
discerning an edible berry from a poisonous berry.
But this benefit also left us vulnerable to optical illusions.
In a similar way, our hardwired processing and emotional reactions help us make quick
decisions.
But these mental shortcuts can also lead to errors in judgment called cognitive biases.
And cognitive biases can sometimes cause investors to make irrational financial decisions.
For example, here's a coin toss.
If it's heads, you lose $100.
If it's tails, you'll win $150.
Would you accept the gamble?
A perfectly rational person would take this risk, because the reward is higher than the
risk.
But people are afraid of losing money.
This type of irrational thinking is influenced by a cognitive bias called loss aversion,
an effect first noticed by psychologists Daniel Kahneman and Amos Tversky.
This loss aversion could potentially hurt an otherwise rational investor.
For example, in 2008, the average annual return for the S&P 500 was -38%.
When faced with such a huge drop, some investors may have been tempted to exit the market to
avoid loss.
However, the average annualized return for the last 20 years was actually closer to 10%.
The loss-averse investor who exits the market during a negative year in an attempt to avoid
more losses will likely miss out on long-term gains.
Even if these investors enter the market again after a downturn, they may not be able to
catch up to the investor who stayed invested.
Some investors may also fall prey to hyperbolic discounting, which is a fancy economist way
of saying people often prefer immediate, but smaller rewards over larger, long-term rewards.
This preference for immediate rewards could prevent people from saving money and investing.
For some people, it's more tempting to spend the extra $100 in their pockets today than
wait for compound interest to potentially grow that money over time.
These types of cognitive biases are part of being human.
To help, there are some strategies you can use.
One way to avoid hyperbolic discounting and save more is by setting up automatic contributions
to your accounts.
And to curb loss aversion, focus on long-term results to avoid exiting the market too early.
A systematic plan with a predefined timeline for rebalancing and withdrawing can help you
stay focused on long-term goals and take psychology and emotions out of the equation.

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Why We Make Irrational Financial Decisions | Simple Steps for a Retirement Portfolio Course

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