Avoiding Pitfalls in Financial Decision Making
Have you ever stopped to think about why or how you made a decision? Was it your logic, intuition, emotion, pressure, or routine? Or were you simply following direction from someone else?
The truth is, we’re all subject to “noise” on a daily basis. Whether it’s the media, colleagues, friends, family, or even strangers—everyone has something to say and an opinion to give. But no matter what is happening around us, we are each responsible for the financial decisions we make. The question is, how do we protect ourselves from the inevitable traps along the way?
In “The Hidden Traps in Decision Making,” Hammond, Keeney, and Raffia highlight the dangers we face subconsciously or consciously when making decisions. In an industry that is driven by investors, emotions, and analysis, this is especially pertinent. Here, we’ll talk about some of those dangers and how creating “guardrails” can go a long way in avoiding pitfalls in financial decision making.
This concept may sound simple, but it’s easily taken for granted. If you have to decide between where to go for lunch and where to invest your retirement savings, for example, choosing lunch is indisputably the easier option. The point is that no matter what choices you’re faced with, you will likely cherry-pick what you want. As such, we all need to be cognizant of our personal decision-making pitfalls and then consider what’s really driving our decisions.
- Are you listening to your gut?
- Are you being influenced by someone or something?
- What is the root of the question?
- Did something happen in your past that you never want to repeat?
In your quest to be more aware in your decision-making process, there will be many traps—some of which occur subconsciously. Here are a few potential pitfalls to be mindful of, plus some tips for managing them.
The anchoring trap. This trap attaches to you like a heavy weight and then influences your decision. To illustrate how it might work, think of the investor who calls you because a friend told him that he should buy a stock or your clients’ reactions when a company's quarterly earnings fall short of estimates and the stock price drops.
Now, put yourself in the investor’s shoes. Stop, breathe, and evaluate. What is really happening? Is there a need to react, or are emotions in charge? In situations such as this, the following steps may be useful for you and your clients:
- Step 1: Identify the anchor. Figure out what is driving your reaction and try to take a different view. For example, is it that a friend told you to buy stock and he or she always knows what’s best? Do you feel pressed for time or that you’ll miss out on an opportunity?
- Step 2: Do your due diligence. When making an important financial decision, come up with your own opinion, but then be open to the opinions of others. Let’s say that earnings estimates drop for one quarter. Is it worth reacting? What caused the drop? Are you being influenced by the media hype and forecasted values based on historical numbers? (Keep in mind that there are factors besides a company’s P/E ratio that should determine its worth. The P/E ratio is only as good as a company’s accounting method, and every company has its own method, although they are typically governed by Generally Accepted Accounting Principles.)