Why it's hard to make a good decision

Recently The Wall Street Journal ran an article entitled, “Training the Brain to Choose More Wisely.” It opened with the sentence, “The human brain is wired with biases that keep people from acting in their best interest.” In the last forty years a field of inquiry has emerged called behavioral finance that has shed new light on how we make investment choices.

Adults tend to think of ourselves as sound decision makers; we make hundreds of decisions each day. Yet we are busy people in a complex world and cannot possibly give in-depth consideration to every choice.

The current financial mess affords no shortage of examples of poor decision-making. Didn't we learn anything from our mistakes in the dot-com era? Many people believed real estate values would keep going up as they had for many years; they were convinced that real estate was still a good investment. This belief, based on a prior set of conditions which turned out not to be sustainable, constituted a biased assessment of risk.

Many investors wanted to buy more property because it appeared that everyone else was making money at it. They were motivated in part by a bias to follow the herd. Now, investors may have a hard time selling investments that have declined in value, even though lower prices may also present better opportunities for buying. Investors in this case may have loss aversion.

A biased assessment of risk occurs when the brain takes a shortcut in evaluating a risky situation.

People do like to go along with the crowd. Yale professor Robert Shiller talks about social contagion. Most people come to think the optimistic view is correct just because everyone else seems to accept it as true.

When it comes to investment decisions, others often influence us, even when following in their footsteps is not necessarily rational or in our best interest. Upon seeing others do something, we tend to ask whether the same might be good for us. We hear that our neighbor got out of the market last November and think maybe we should do the same.

It should come as no great surprise that people hate losses. Loss aversion, however, can elicit unproductive and irrational behavior. People have an extremely hard time selling a stock or fund that has sustained a loss. Recognizing a loss is equivalent to acknowledging having made a mistake. This leads to the crafting of excuses. We cling to the fond hope that the investment will return to its previous value. If it could just get back to where it was when we bought it, then we would sell. We hope the market will validate the original purchase.

People tend to make poor decisions because they fear losing or giving up something, even though change is very much in their best interest.

Knowing oneself is a vital aspect of successful investing. Investing entails risk. Knowing our own temperament for risk (and that of our spouses) will lead to knowing the returns you will get.