What was the last decision you remember making? Opening this email or clicking on this link, perhaps? Do you remember why you made that decision? I'm betting you haven't got a clue because it was automatic. If not, then your brain is making up a story to justify the decision.
We Make 1-9% Of Our Decisions Logically
Believe it or not, we are aware and consciously make only 1-9% of all our decisions. Having trouble believing me? You make 35,000 decisions per day. How many do you remember making? Of those you remember making, for how many do you remember the reason?
The rest of the decisions are made either instinctively by our reptilian or lizard brain, or emotionally by our mammalian or monkey brain. Have you ever wondered why training helps us make better decisions (sports, music, martial arts, etc.)? They call it muscle memory and it is the process of training these movements to be instinctive. That way we don't have to think about it. Our thinking brain is slow; our instinctive brain is fast.
Taking Shortcuts and Making Up Stories
It's very easy for us to believe we are the authors of most of our decisions because our brain justifies our decisions afterward, trying to fit the decision into our world view. Just last weekend I had to go to the store to buy some toothpaste. Now, if you haven't been to the toothpaste isle lately, allow me to describe it for you. The whole isle is full of toothpaste. Many brands. Many types within each brand. Single tubes. Three packs. Six packs. How is anyone supposed to make a decision? We don't have the time to compare every single option so our brains take shortcuts. If you asked me after I made my decision I would have told you that the three pack I bought was a good bargain and I didn't want to buy more than three tubes at once because of space concerns. But that's nonsense. I can't know why I made the decision.
We Aren't Rational Creatures
Taking these shortcuts leads us to make "good enough" decisions instead of "optimal" decisions. There are many ways in which we process information incorrectly, or emotionally hold on to previous decisions or beliefs. This doesn't exactly jive with the likes of traditional finance.
Behavioral Finance Is Born
Since we are not all perfectly rational decision makers, a new field was born to try and explain the world through the lens of people who don't make rational choices. Some of the kingpins in behavioral finance are Daniel Kahneman (Thinking Fast and Slow), Richard Thaler (Nudge: Improving Decisions About Health, Wealth, and Happiness), and Dan Ariely (Predictably Irrational: The Hidden Forces That Shape Our Decisions). I personally recommend anything by these authors if you are interested in learning more.
Behavioral finance is the application of psychology to finance. Specifically (to all my nerds out there), it's the application of cognitive psychology to finance; not to be confused with financial psychology, which is the application of clinical psychology to finance. Behavioral finance is the "nature" or how we're all wired, and financial psychology is the "nurture" or how YOU are wired.
They Call Them Errors and Biases
There are many biases we have when making decisions. Sometimes you'll hear them called "errors." I can get on board with "biases" but I don't like the word errors. It implies that there is something wrong with the decision maker; that he or she made an error or a mistake. It misleads us into thinking that we are dumb.
Our biases can be caused by how our minds process information, us holding on to previously held beliefs, or because our emotions get in the way. These types of biases can cause us to put too much weight on new information, ignore information altogether, or be too quick to accept information that conforms to our previous beliefs.
Simply Knowing Can Help
No matter how these biases influence us, just knowing that we are susceptible to these biases can help us make better decisions. Sometimes it's helpful to implement systems that make it easier for us to make the right decisions; for example, instead of trying to avoid buying donuts for breakfast perhaps we have a rule that we don't even go to that part of the grocery store.
The point is that with some mindfulness and practice, you can make smarter decisions, especially with your money - even if your emotions are calling the shots.
Dan Ariely: Predictably Irrational
Dan Ariely, Jeff Kreisler: Dollars and Sense
Daniel Kahneman: Thinking Fast and Slow
Michael Pompian: Behavioral Finance and Wealth Management
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