Humans are biased. Don't think of these biases as "bad" or "good". They just ARE there. These "cognitive biases" have developed to help humans survive, and make judgments about the complex situations we are presented day to day. Some of these biases can help you make great decisions; some can hurt big time.
I am going to talk about a few biases that can hurt our financial planning - of interest to those in this sub.
What if your estimates of future income/investment gains were OVER-ESTIMATED? What if, furthermore at the same time, your estimates of your future expenses were UNDER-ESTIMATED? This would be like taking a 2 by 4 across your financial plans. And, this is what faces most of us unless we really understand our biases that shape our decision-making.
Research has shown that we exhibit “unrealistic optimism” (http://ift.tt/2n9NSxk) [PDF]— we assume that the good times will continue to be good, and further that, any bad times will affect us less. In addition, we are afflicted with “projection bias” (http://ift.tt/2AuaY8m) [PDF] where people assume that others think like them — hence, believing mistakenly (at times) that the future they favor is more likely than it actually is. See this awesome article by Caroline Beaton in The Atlantic for a good overview - http://ift.tt/2h5YhMq
Let’s look at common income/expense biases (we use the term “income” to refer to anything that contributes positively to net-worth [rents, dividends, interest, stock gains, etc.]).
Income Biases:
- “I will get an above average raise because I work hard”;
- “My job is secure even though others around me in my company are losing theirs.”
- “If I leave to join another company, I expect to get the same/increased wages.”
- “I have been getting an average annual return of 7–10% in the market the last few years. I expect that to continue in the future.”
- “The last few stock picks I made were winners. My next few will be winners too.”
- “The stock I bought has dipped below the price I purchased it at. I am pretty sure it will come back up.”
- “It’s my talent that causes me to make money in the market. It’s bad luck when I lose it.” For those who think this, please read Nassim Taleb’s excellent “Fooled by Randomness.” (http://ift.tt/29yUDSm)
Expense Biases:
- “My expense patterns of the last few years will continue into the future.”
- “I have been healthy until now. I do not see this changing. Hence, there is no need for me to budget additional expenses for out-of-pocket health costs.”
- “If I lose my job, I don’t anticipate being out of work for very long. So no need to increase the amounts I put away in my rainy-day fund.”
- “My parents are getting old. But I see no reason to budget additional dollars to their care. They will manage, as they have in the past.”
Avoiding Bias
It’s hard to avoid the self-interested biases we have. Even the best of us like Warren Buffett suffer from them. Buffett, for example, chronicles how having bought one failing textile company in the 1960s, he proceeded to buy another! His bias? He knew textiles.
The best way to avoid biases is to look for alternate sources of information, viewpoints that contradict yours. Start thinking not in absolute terms (“My returns over the next decade will be pretty good.”) but rather in terms of probabilities (“what is the probability that my returns will be good? Bad?”).
The “Good Judgement” Project run by Prof. Tetlock may be a good place to start to hone your “probabilistic” way of thinking (see https://www.gjopen.com/)
A way to mitigate the ill-effects of your biases is to compensate for them — dampen positive expectations of returns (in the market), and increase the expectations of negative outcomes (in terms of expenses). Your biases may still hurt you but hopefully less so.
To learn more about biases that shape our thinking (in general), I'd recommend "Thinking Fast, Thinking Slow" by Daniel Kahneman (http://ift.tt/1Yv4qxz). Prof. Kahneman won the Nobel Prize in 2002 for Economics for this work (done jointly with the late Prof. Amos Tversky). To read about the amazing collaboration of these two intellectual heavyweights, read "The Undoing Project" by Michael Lewis. (http://ift.tt/2AvbMKj)
Good luck - and may your plans henceforth be more firm!
Submitted November 09, 2017 at 07:49AM by arnexa http://ift.tt/2ym2ChS
