One of my bittersweet favorite behavioral science books is Daniel Kahneman’s Thinking, Fast and Slow. I consider it the book that pulled off my blinders and ruined my life. Kahneman, who won the Nobel Prize in Economics, and his colleague, the late Amos Tversky, researched contradictions in human behavior. This book lays out our methods for decision making and the short-cuts our brains take—heuristics (essentially, rules for problem solving) and biases. Methods that work really well a lot of the time and cause us to make mistakes, repeatedly, in often predictable circumstances. After a lifetime of considering myself a good, rational, analytical decision maker (spoken like a true control freak), Kahneman revealed that to be just a front, not even a very good one. It’s hard to accept being human, making decisions for all kinds of reasons that have little to do with sound analysis. And Thinking, Fast and Slow isn’t a self-help book—Kahneman doesn’t believe that by recognizing our biases and tendencies to take short-cuts when making decisions we can eradicate them. They’re the way we’re put together. Nevertheless, in today’s blog post, we’re going to take on a few of our mental traps. I operate under (or suffer from) these and maybe you do, too.

Weighing risk

As a financial planner, I help my clients choose their own personal risk/reward balance on the path to achieving their goals. Often part of financial planning is setting up an investment portfolio to provide resources for future goals—sending a child to college, taking a dream vacation or funding retirement. To do this well, we need to consider both the client’s risk attitude—the willingness to stay invested through inevitable market declines, and risk capacity—the level of risk required in order to have a high likelihood of meeting the client’s goals.

While there’s no guarantee that history will repeat itself, historical investment performance is the best tool we have for estimating a reasonable range for the future and then to determine risk capacity. For example, if I have a $500,000 investment portfolio and I want to be able to draw $25,000 per year through a 30 year retirement, risk capacity won’t allow me to invest solely in U.S. treasury bonds. With a current yield of less than 1.5%, I’ll run out of money before I hit the 30 year mark. So risk capacity says that I have to move up the risk scale, investing part of my portfolio in higher yielding stock, in hopes of earning a return adequate to fund my goal.

Now if I have a very conservative risk attitude, I may decide that I’ll be happier sticking with those long term treasuries and reducing my annual draw to $20,000. That’ll work. Or I can decide that $25,000 is truly my number and I’m going to learn to live with a bit more risk in order to get it. Either my goal or the level of investment risk I’m willing to take on will have to change. But, in a perfect world, I would then pick an appropriate investment mix of stock and bonds to achieve my goals and leave it there.

Meanwhile, back on planet Earth

In the real world, we have humans calling the shots. Humans are prone to shifting perceptions based on the world we observe. So, for example, our perception of the risk of investing in stocks changes with the stock market’s performance. Some of those very biases and heuristics that Danny Kahneman used to ruin my life come in to play (I don’t think he did it maliciously—he doesn’t even know I exist!). When the market goes up and up for years and years, as we saw in our recent long-running bull market, we are affected by an availability heuristic—the likelihood to overestimate events based on what is available in our memory. Availability is influenced by how recently a memory occurred or how emotionally charged or unusual it is. Our recent experience is that stocks rise and rise. The availability heuristic leads us to extrapolate this growth trend far in to the future. This expectation, however flawed, makes stocks feel less risky. During a bull market, an investment portfolio starts to feel too conservative—we think we have too large a portion invested in bonds and cash, we’re afraid we’re missing out on too much of the upside. Our circumstances haven’t changed, our goals haven’t changed, only our perception of risk is altered. If we act on this perception, we buy stocks on the upswing.

When the inevitable correction arrives, like the one we experienced in March, our risk perception changes again. Now the availability heuristic has us assuming that the down market we’ve seen is going to persist on in to the future. We can easily fall prey to two additional biases:

Confirmation bias: We are more likely to notice information that confirms what we already believe. If the availability heuristic says the market will decline, confirmation bias adds fuel, in the form of corroboration, to the fire.

Overconfidence: With availability and the confirmation bias hard at work, we believe that we actually do know what is coming.

All of this adds up to a new perception that our portfolio is too aggressive. Now is the time to dial back on stocks so we don’t get further hammered as the market continues to decline. Again, neither our circumstances nor our goals have changed, but our risk perception has. And it is telling us to sell stocks. If we act, we’re selling on the downswing.

Buying on the upswing, selling on the downswing—isn’t this the exact opposite of that golden rule—buy low, sell high? Acting on our changing perception of risk has us forever chasing a volatile market, losing ground all of the way. I know this from personal experience, not only from reading the research or stories about other people. Shortly before the tech bubble burst in 2000, I decided that my cash wasn’t earning a decent return and that I was missing out on tech stocks. Heck, people I knew who didn’t know anything about stock analysis were making money on tech stocks…and it just kept going up and up. Does this sound like a mix of availability, confirmation and fear of missing out? I knew better than to invest money I might need in the next couple of years, but I did it anyway. Bought at the top. And we did end up needing the money in the next two years and selling those tech stocks at the bottom of a bear market. Ouch! Welcome to the human race!

Resisting the temptation

How do we break this cycle? It isn’t easy, but in order to meet our goals, we need to try. Here are my recommendations:

• Make sure that your investment strategy takes into account both your risk attitude and your risk capacity. You want to be able to sleep at night while having a good likelihood of reaching your goals.

• Be aware of the short-cuts we’re likely to take in decision making: availability, confirmation bias and overconfidence.

• Put in place an accountability system that is triggered before you change your investments. This could be a mandatory conversation with a friend who has agreed to question your reasoning. Or work with a financial planner who can both help you define the investment strategy that’ll let you reach your goals and stay on track.

Want a professional to help you decide how much risk you need to take and then stay the course? Give me a call (336-701-2612) or send me a message.

Investment advisor representative of and investment advisory services offered through Garrett Investment Advisors, LLC, a fee-only SEC registered investment advisor. Tel: (910) FEE-ONLY. Fair Winds Financial Advice may offer investment advisory services in the States of North Carolina and Texas and in other jurisdictions where exempted.