How Behavioral Finance Can Help You Set and Keep Financial Goals

Dr. Daniel CrosbyDr. Daniel Crosby, President, IncBlot Behavioral Finance

If you’re ever having trouble sleeping, spend some time researching financial goal setting online and you’re sure to be snoozing in no time. It’s not that the advice you’ll find is bad per se, it’s just that it is fundamentally disconnected from an understanding of how people behave. Most resources will give you some great meat-and-potatoes stuff about setting specific, attainable and timely goals. You will nod your head, go home, and forget all about it, doing what you’ve always done before.

If financial goal setting is to be truly successful, it must account for the way in which people behave, including the really stupid stuff we all do from time to time. What’s more, it must be infused with elements that make it motivational, because let’s face it, you’d probably rather get a root canal than lay out a spreadsheet with some dry figures about Set Your Goalsyour savings goals. To help in this important step, we’ve mixed some best practices in financial planning with some truths about human nature that will add a little, dare we say it, excitement into your financial planning process. After all, your financial goals are only as good as your resolve to adhere to them is strong.

The next time you go to set a financial goal, consider the following:

Plan for the Worst – Cook College performed a study in which people were asked to rate the likelihood that a number of positive events (e.g., win the lottery, marry for life) and negative events (e.g., die of cancer, get divorced) would impact their lives. What they found was that participants overestimated the likelihood of positive events by 15% and underestimated the probability of negative events by 20%.

What this tells us is that we tend to personalize the positive and delegate the dangerous. We think, “I might win the lottery, she might die of cancer. We might live happily ever after, they might get divorced.” We understand that bad things happen, but in service of living a happy life, we tend to think about those things in the abstract. A solid financial plan cannot assume that everything will be wine and roses as far as the eye can see.

Picture Yourself at 90 – One of the reasons that we tend to under prepare for the future is that we value comfort now more than we do in the future. Simply put, the further out an event is, the less valuable we esteem it to be. Let’s say I offered you $100 today or $110 tomorrow. Odds are, you’d use a little bit of self-restraint and go for the extra ten dollars. What if I changed my offer to $100 today or $110 in a month? If you are like most people, you’d take the $100 today rather than wait the extra 30 days. The official term for this devaluation over time is “hyperbolic discounting” and it can have disastrous consequences for managing wealth over a lifetime.

Crosby_BeFi_Help_Set_Goals_2After all, if today’s needs and today’s dollars always perceived as more valuable than tomorrow’s wealth and wants, we’ll make hay while the sun shines. While this can be fun in the moment, your older self is not going to be too happy eating Top Ramen every night. One of the ways to decrease our tendency toward hyperbolic discounting is to make the future more vivid. Researchers at New York University did this by using a computer simulation to age peoples’ faces and found that “manipulating exposure to visual representations of one’s future self leads to lower discounting of future rewards and higher contributions to saving accounts.” Basically, if you can picture yourself wrinkly, you’re more likely to save. Making your own future vivid might include having conversations about your future with your partner, speaking with aging relatives or simply introspecting about your financial future.

Bake In Motivation – Daniel Pink’s seminal work, “Drive” is a concise treatise on what he believes are the three pillars of human motivation – mastery, autonomy and purpose. By including each of these three pillars in the financial goal setting process, you “bake in” motivation, thereby increasing the likelihood of meeting those aspirations. Mastery is all about fluency with the language of finance. While you may never be Warren Buffett, achieving mastery is the first step toward staying motivated. We procrastinate what we don’t like or don’t understand. Once you are facile in the language of numbers, you’ll stop putting your finances on the back burner.

The word “autonomy” is derived from the Greek word “autonomia”, the literal translation of which is “one who gives oneself their own law.” Being autonomous does not mean going it alone. What it does mean is having enough of an understanding of financial best practices that you can select financial professionals whose goals and approaches mimic your own. Finally, and most importantly, is purpose. One of the biggest culprits in bad financial planning is disconnecting the process from the things that matter most to the person making the decisions. Coco Chanel said it best when she said, “The best things in life are free; the second best are very expensive.” Financial solvency facilitates all manner of good, from charitable giving to family vacations to funding an education. If your financial goals are intimately connected to things that matter most to you, saving will cease to be a chore and begin to be a joy.

Views expressed are for illustrative purposes only. The information was created and supplied by Dr. Daniel Crosby of IncBlot Behavioral Finance, an unaffiliated third party. Brinker Capital Inc., a Registered Investment Advisor

Planning Fallacy

Dr. Daniel CrosbyDr. Daniel Crosby, President, IncBlot Behavioral Finance

Last November, my wife and I were blessed with the birth of Liam, our second child and first son. My wife, who had diligently prepared for all aspects of the baby’s arrival, had been encouraging me to prepare my overnight “go bag” in the case of an early arrival. As I am wont, I put this final preparation off until the last minute, only preparing a very few basic necessities and wrapping them unceremoniously in a Walmart bag rather than the leather duffel I use for most business travel.

Our son arrived without adverse incident (easy for me to say!) and as we hunkered down for those difficult, sleepless first nights in the hospital, I realized that my preparations had been inadequate. I had forgotten my contacts entirely, brought an outdated pair of prescription glasses and packed only enough clothing for one day following the delivery. Needless to say, the discomfort of those late nights in the hospital was only made worse by my lack of foresight. Not only was I sleepy, as is to be expected; I was also smelly, unshaven and outfitted in yesterday’s rumpled t-shirt. Luckily, the miracle of new life minimized my failure to prepare, but the (seemingly millions) of pictures will always tell the tale of just how unprepared I truly was.

Crosby_PlanningFallacy_4.3.14So how is it that I, an otherwise functional person who had been through this experience once before, was caught so off guard? The psychological term for what I had experienced is the planning fallacy and it is the reason that we are often a day late and a dollar short. In a phrase, the planning fallacy is the human tendency to underestimate the time and resources necessary to complete a task. In my case, the damage was limited to a few unfortunate pictures, but when applied to a lifetime of financial decision-making, the results can be catastrophic.

There are a variety of hypotheses as to why we engage in this sort of misjudgment about what it will take to get the job done. Some chalk it up to wishful thinking. To use my example, I was hoping to be in the hospital just two nights instead of the five we spent when my daughter was born. By packing a small bag, I was willing this dream into existence. A second supposition is that we are overly-optimistic judges of our own performance. Extending this line of thought, I might understand that most couples are in the hospital for three nights but most couples are not as fit, intelligent and strong-willed as the two of us (to say nothing of our exceptional progeny!). A final notion implicates focalism or a tendency to estimate the time required to complete the project, but failing to account for interruptions on the periphery. Sure, it may just take a few hours to have the baby, but there is recovery, eating, entertaining visitors, and the requisite oohing and aahing over the new arrival.

Whatever the foundational reasons, and it is likely there are many, it is clear enough that the American investing public has a serious case of failure to adequately plan. Excluding their primary home value, most Americans have less than $25,000 in retirement savings. 43% of Americans are just 90 days away from poverty and 48% of those with workplace retirement savings plans fail to contribute. Perhaps we think we are special. Maybe we are simply too focused on the day-to-day realities that can so easily hijack our attention. Without a doubt, we may wish that the need to save large sums of money for a future date would just resolve itself. But wishing it won’t make it so any more than wishing for my son’s hasty arrival did. I got off no worse than a few bad pictures and some unsightly hair; those who plan to save for their financial tomorrow’s won’t be nearly as lucky.

Views expressed are for illustrative purposes only. The information was created and supplied by Dr. Daniel Crosby of IncBlot Behavioral Finance, an unaffiliated third party. Brinker Capital Inc., a Registered Investment Advisor

How to Become an Informed Consumer of Financial News

Dr. Daniel CrosbyDr. Daniel Crosby, President, IncBlot Behavioral Finance

Whenever given a microphone and a stage, I take the opportunity to warn investors and financial professionals alike against the harm of keeping too close a tab on the financial news. Since my exhortations to turn off the TV are so roundly ignored, I’ve decided to take a new tack—exchanging media abstinence with “safe watching” as it were. With investors, as with unprepared teenagers, the only sure-fire way to avoid trouble is to leave it alone altogether. However, being the realist that I am, I hope to provide some tips for safe viewing that will allow you to indulge without contracting “media transmitted irrationality.”

Of course, the irony of warning you about the ills of financial media via, well, financial media, is not lost on me. However, the very fact that you are here means that you may have a problem. Gotcha! It is a strange thing that an awareness of current financial events can lead to worse investment outcomes. After all, in most endeavors, greater awareness leads to improved knowledge and results. So what accounts for the consistent finding that those who are most tuned in to the every zig and zag of the market do worse than those who are less plugged in?

Informed ViewingThe first variable at play is timing. I won’t bore you with an extended diatribe on short-term market timing, but the fact remains that average equity holding periods have gone from six years to six months in the last five decades. This national case of ADHD has been precipitated in part by advances in trading technology, but is further exacerbated by the flood of information available to us each day. Unable to separate signal from noise, we trade on a belief that we are better informed than we are.

Another damning strike against financial media is that the appetite for new content flies in the face of investing best practices. Warren Buffett famously advised investors to imagine they have a punch card with 20 punches over the course of an investing lifetime. By espousing this strategy, Buffett encourages a policy of fewer and higher-quality stock selections, encouraging downright inactivity in some cases. Compare this time-tested approach with the demands placed on the financial press. Each night, Jim Cramer picks 10 stocks to pass along to his viewers to help sate the national appetite for cheap investment advice and the erroneous belief that more is better. Cramer has used up his whole punch card before Wednesday, and it’s not because it’s a sound investment strategy, it’s because it sells commercials.

Consumers of financial media who fail to account for these sorts of perverse incentives can feel disillusioned when the advice of such vaunted “talking heads” leads them so far afield. Conversely, a more informed consumption of media can enable each of us to separate wheat from chaff and learn to recognize a bona fide expert from a circus clown in a $2,000 suit. The following tips are a great place to start:

Evaluate the source. Does this individual have the appropriate credentials to speak to this matter or were they chosen for superfluous reasons such as appearance, charisma or bombast?
Question the melodrama. While volatility can be the enemy of good investing, chaos and uncertainty are a boon to media outlets hungry for clicks and views.
Examine the tone. Does the report use loaded language or make ad hominem attacks? These are more indicative of an agenda than an actual story.
Consider motive. News outlets are not charitable organizations and are just as profit-driven as any other business. How might the tenor of this report benefit their needs over yours as a decision maker?
Check the facts. Are the things being presented consistent with best academic practices and the opinions of other experts in the field? Are facts or opinions being expressed and in what research are they grounded?

Financial media is always going to have an angle, but so do you and so does every person with whom you’ll interact. That being so, the best strategy is to become skeptical without being jaded and cautious without being paralyzed by fear. If you found yourself thinking, “Who the hell is this guy to lecture me on media consumption?” you’re off to a good start.

Views expressed are for illustrative purposes only. The information was created and supplied by Dr. Daniel Crosby of IncBlot Behavioral Finance, an unaffiliated third party. Brinker Capital Inc., a Registered Investment Advisor

The Power of Purpose: The Benefits of Goals-Based Investing

Dr. Daniel CrosbyDr. Daniel Crosby, President, IncBlot Behavioral Finance

I recently had the opportunity to speak about how investor behavior is a driver of the future of the financial services industry and the impact that it has when working with clients at the 2014 FSI OneVoice conference in Washington, D.C.

Much of behavioral finance’s departure from traditional financial models centers on the respective approaches’ vision of what constitutes “rational” behavior. Traditional approaches take a simple, objective approach—rational behavior is all about optimizing returns. Through a behavioral lens, rationality takes on a more subjective view and could be construed as making decisions consistent with personal financial goals. The behavioral approach is constructivist, in that the client sets the parameters for rationality through the articulation of personal goals. But by drawing out the financial goals of their clients, advisors do more than simply highlight a finish line; they actually catalyze a positive behavioral chain reaction.

Consider the followings ways in which having deeper conversations about client goals might make your job easier and improve your clients’ behavior:

Crosby_PowerofPurpose_3.6.14Purpose increases influence – The reasons why successful advisors are highly compensated and most trainees burn out within a few years are one in the same–selling is difficult. All too often, advisors are selling the wrong thing, focusing on the “What?” instead of the “Why?” In his excellent TED talk, Simon Sinek suggests that most uninspired business transactions deal with the particulars of a product or service rather than the underlying motivation. Rather than providing your clients with a laundry list of your services, help them understand how your efforts will help them reach their “why.” As Sinek says, “People don’t buy what you do, they buy why you do it.”

Meaning brings clarity – One of the reasons why people fail to save in the now is that it is construed as a loss. In an environment where expensive trinkets can tempt us with each click of the mouse, it can be difficult to put off for a rainy day what could provide more immediate pleasure. Once again, a goals-based approach can help. We know we need to save for some distant date, but the picture we have of the future tends to lack color, which can making saving a burden. By articulating a series of future meaningful goals, advisors can ensure that their clients have this larger “yes” burning inside.

Crosby_PowerofPurpose_3.6.14_2Goals provide comfort in hard times – Viktor Frankl, the Austrian psychiatrist and Holocaust survivor, has written beautifully about the power of purpose in his classic, “Man’s Search for Meaning.” Frankl noticed early on that much of what differentiated hope from a failure to thrive among prisoners was a connection to something bigger than the here and now. For those rooted in the horror of the present, it was exceedingly easy to find reasons to despair. But for those able to look forward to something more, their pain was couched in terms of aiding their long-term goals, which provided them some succor.

While I am in no way trying to draw a straight line between Frankl’s experience and that of a worried investor in a time of market panic, the truth remains that focusing on purpose has a calming effect. Rather than being swept up in the pain of the moment, goals-based investors are better able to understand that they are enduring a momentary discomfort on the path to achieving the things that matter most to them. Are your clients sufficiently tuned in to their personal North Star to aid them when times get rough?

If behavioral finance has taught us anything, I hope it is that true wealth is more about a life well lived than achieving a particular rate of return. In a single act, advisors can improve relationships with their clients, get them excited about the investment process and provide them with a buffer against hard times. Why not?

Views expressed are for illustrative purposes only. The information was created and supplied by Dr. Daniel Crosby of IncBlot Behavioral Finance, an unaffiliated third party. Brinker Capital Inc., a Registered Investment Advisor

Brinker Capital at the Financial Services Institute OneVoice 2014 Conference

Noreen BeamanNoreen Beaman, Chief Executive Officer

In June, we announced Brinker Capital as a Premier Sponsor of the Financial Services Institute (FSI), a voice of independent financial services firms and independent financial advisors.  FSI’s mission is to ensure that all individuals have access to competent and affordable financial advice, products and services.

FSI’s OneVoice 2014 Conference kicks off next week in Washington, D.C. where Brinker Capital is proud to be a Premier Sponsor as well as a presenter.  OneVoice is FSI’s annual conference for the independent broker/dealer community to network and gain knowledge of the latest within the industry.

FSI OneVoice Conference 2014We are honored to have our Vice Chairman, John Coyne, chosen as a panelist for the Alternative Investment panel; our Vice President of Business Administration, Brendan McConnell, as a panelist to share insight on the latest technology tools to help advisors gain efficiencies; and behavioral finance expert, Dr. Daniel Crosby, as a presenter on understanding investor behavior.

This year’s conference promises to be a good one as FSI celebrates 10 years of advocacy for independent financial service advisors and firms.  We look forward to seeing many of you there!

Behavioral Finance 101: Framing

DanielCrosbyDr. Daniel Crosby, Ph.D., IncBlot Behavioral Finance

As we’ve discussed in the first two parts of this series, economic decision makers are not the cold, detached, decision makers they have historically been painted to be by efficient market theorists. Quite the opposite, human behavior is marked by irrationalities and fuzzy logic based more closely on mental approximations than hard and fast rules. We have already touched upon the impact of heuristics and irrational behavior and today will turn our gaze to the third pillar of behavioral finance – framing.

7.10.13_Crosby_Framing_2Simply put, framing is an example of a cognitive bias in which people arrive at a different decision depending on how the question is framed. While homo economicus would weigh all decisions equally and disregard framing effects, actual behaviors indicate that the lens through which we view a decision has everything to do with the eventual outcome. Frames can take a number of shapes; it could be the physical place where we make a decision, whether a question is positively or negatively framed, and even the way we mentally account for the options from which we are selecting.

Consider a real-life framing example with a huge cost to the U.S. taxpayer. Twice in the past few years, the government has tried to stimulate the economy by offering tax rebates to the hardworking citizens of the U. S. of A. Both times, these efforts have met disappointing ends, and behavioral finance may just be able to tell us why.

Belsky and Gilovich lead us toward the answer in their excellent primer, “Why Smart People Make Big Money Mistakes.” They describe a study conducted at Harvard wherein 24 students were given $25 to spend in a lab store as part of their participation in a research. Any unspent money, they were told, would be returned to them shortly via check. But wait, there’s a rub (there always is when psychologists are involved)! Half of the students were told that the $25 was a “rebate” and the other half told that it was a “bonus.” Could such a minute difference in cognitive framing have a measurable impact on spending behavior? It turns out, it could.

7.10.13_Crosby_Framing_1For those whose earnings were framed as a bonus, 84% spent some money in the lab store, a behavior mimicked by only 21% of those whose money was framed as a “rebate.” Now consider the decision of the U.S. government to give “tax rebates” to help stimulate the economy—an action that ultimately failed, probably at least in part due to framing effects. Irrational decision makers that we are, we fail to grasp the fungible nature of dollars and account for them differently based upon how they are framed in our mind. As Nick Epley, the psychologist who conducted the Harvard study, said more forcibly, “Reimbursements send people on trips to the bank. Bonuses send people on trips to the Bahamas.”

One of the most profound forms of framing effect plays on our fear of loss in times of fear or risk, or the related fear of missing out in times of plenty. This tendency, demonstrated most powerfully by Daniel Kahneman and Amos Tversky is known as “loss aversion.”[1] The basic tenet of loss aversion is that people are more upset a loss than they are excited by an equivalent gain. Consider the comical demonstration of loss aversion that resulted from a survey conducted by Thomas Gilovich. Mr. Gilovich asked half of the respondents to a questionnaire whether or not they could save 20% of their income, to which only half said yes. The second half of the respondents was asked whether they could live on 80% of their income, to which 80% replied in the affirmative. To-may-to, to-mah-to, right? So why are the responses so different?

7.10.13_Crosby_Framing_3The first phrasing frames it as a 20% loss of spending power (there is a large body of research that indicates that saving is viewed as a loss. Silly people), whereas the second frames it more positively. Thus, equivalent financial realities are viewed through entirely different lenses that lead to decisions with profoundly different outcomes.

One of the benefits of behavioral finance is that it shines a light on the little peccadilloes that make us the flawed but lovable people we are. But irrational as we may be, we can turn the tide on ourselves and use these quirks to our personal advantage. Framing is only disadvantageous inasmuch as the frames we are applying to our money are reckless. Viewing money through the frame of a charitable contribution or a child’s college fund can impact your financial decision positively just as surely as framing it as disposable can have a negative impact. At Brinker Capital, our Personal Benchmark system accounts for the human tendency to mentally account for and frame dollars, and does so in a way that helps ensure an appropriate allocation of assets across a risk spectrum. As we hope you’re aware after taking part in this behavioral finance survey course, you are not as logical and dispassionate as you might have guessed. Whether or not you use that irrationality to your benefit or detriment is now up to you.

[1] Kahneman, D. and Tversky, A. (1984). “Choices, Values, and Frames”. American Psychologist 39 (4): 341–350.

Behavioral Finance 101: Irrationality

DanielCrosbyDr. Daniel Crosby, Ph.D., IncBlot Behavioral Finance

In part one of our three part series, we touched on “heuristics”, or the experiential rules of thumb that serve as decisional markers. Part two will discuss a second pillar of behavioral finance, irrationality. But before we can talk about irrationality in any meaningful way, we must define what it means to be irrational.

One of the hallmark difficulties of psychology as a science is that it requires “operationalization” of the subjective variables it hopes to measure. That is, it must provide sometimes-ethereal constructs such as happiness or rationality with a set of parameters that allow them to be measured and interpreted. When traditional economic models were constructed, they needed to account for things such as “utility” that had to be operationalized to be accounted for within the model.

Using the logic of the time, they put forth the seemingly straightforward maxim that a rational investor, homo economicus, would act to maximize utility at all times, with utility being defined as dollars and cents. Basically, economic decision makers would consistently act in such a way that their investment returns would be improved to the extent possible.

5.22.13_Crosby_Blog2This idea of rational investors working to maximize returns had two profound positives that served it well over the many years it enjoyed preeminence: 1. It had intuitive appeal 2. It was easily measured. After all, do not most of us engage in all manner of unpleasantness (e.g., staff meetings) to make a buck? And are not dollars more easily debited and credited than say, units of happiness or some other more vague notion of utility? Resting on these two foundational strengths, the idea of rational, wealth-maximizing investors persisted for decades…until the music stopped playing.

Four hundred years ago, in one of the first speculative bubbles on record, a Dutch commodity traded for 10 times the annual salary of a skilled laborer. In some cases, this commodity fetched as much as 12 acres of prime farmland and even single family dwellings.

The commodity of which I’m speaking is a single tulip bulb.

5.22.13_Crosby_BeFiBlog_2_pic2You see, it was thought that tulips were an investment that would always appreciate in value and were immune to the ups and downs of comparable tradable goods. Fast forward three hundred years to 1925 and you would have heard statements like this from the investment gurus of the day…”there is nothing that can be foreseen to prevent an unprecedented era of prosperity.” Sure there had been disastrous crashes in the past, but this time was different.

It’s comforting to think of New Era mindsets as a relic of the past, a trick of the mind that fooled investors less savvy than ourselves. But as recently as the Great Recession of the past five years and the tech bubble of the turn of the century, New Era Thinking has been more present than ever. In the wake of these most recent crises there has been a dramatic uptick in the acceptance of the fact that investors are simply not rational. Quite the contrary, we engage in a number of irrational behaviors that can thwart our best efforts at financial security. This danger is especially real inasmuch as we remain unaware of their impact.

In 1998,, an internet upstart, had sales of $30M, profits of -$28.6M and a total market capitalization of $8 billion. Toy veteran Toy’s R Us on the other hand, had more than 40 times the sales but only ¾ of the total stock value. The advent of the internet was greeted by Wall Street with great enthusiasm, such great enthusiasm that people lost their minds. The thought that the web would revolutionize the way we do business was correct, but the notion that financial fundamentals no longer mattered was not.

5.22.13_Crosby_BeFiBlog_2_pic3Another example of investor irrationality is the belief that our mere involvement with an investment will make it more profitable. A recent study found that people were willing to pay a mere $1.96 for a lottery ticket with 1 in 50 odds if they were assigned a ticket randomly. However, if they were able to choose their number from among the 50, they were willing to pay $8.67 for the ticket. The odds remained at 2%, but the participants agreed to pay over four times more if they could become personally involved. After all, they felt their involvement spelled positive change. It goes without saying that paying four times as much for something with no measurable increase in the probability of success can hardly be called rational.

I could go on, but the point here is not to erode your confidence or create a lengthy list of your imperfections. The point is to heighten your awareness of the potential for irrationality to damage you financially in ways that have a real impact on you and your loved ones. After all, you can’t correct for what you don’t acknowledge. If there is any good to come out of the trillions of dollars in capital that vanished during the bubbles of the last 13 years, it may be that we have been permanently and irrevocably humbled and have a greater sense of the limits of our own rationality. Hopefully we’ve learned our lesson. Hopefully, this time really is different.

Behavioral Finance 101: Heuristics

DanielCrosbyDr. Daniel Crosby, Ph.D., IncBlot Behavioral Finance

While the field of behavioral finance has been around for 40 or so years (depending on who you ask), it truly came into its own in 2002 when Daniel Kahneman received the Nobel Memorial Prize in Economics for his work around uncertainty and decision-making. Although he claims never to have taken an economics class, Kahneman’s work shed new light on the ways in which actual people behave under real-life circumstances, as opposed to the idealized assumptions of efficient market hypothesis, the theretofore ascendant paradigm for understanding investment outcomes.

While one of the nagging critiques of behavioral finance is that it has no mutually-agreed-upon philosophical framework, most psychologists divide it into three pillars: heuristics, irrational behavior and framing. Over the next few weeks, we’ll take each of those three pillars and try and understand them a little more deeply. In so doing, we’ll also tackle the “so what” of behavioral finance for the average investor. Without any further adieu I give you Part One of our survey course on behavioral finance – Heuristics.

I’m not sure what time of day you’re reading this, but whenever it is I can be sure of one thing: you’ve already made a lot of decisions today. First of all, there was whether or not to hit the snooze button. Then, what to have for breakfast? Luffa with body wash or bar soap in the shower? Grey suit or navy suit? And so on and so forth. The point is, given the myriad decisions we all face every day, it’s no wonder that we end up relying on heuristics or experiential rules of thumb, when making even important decisions. To give you a little firsthand experience with heuristics, I’d like to ask you to do the following:

5.9.13_Crosby_BeFiBlog_1Quick! Name all the words you can that begin with the letter “K.” Go on, I’m not listening. (Insert Jeopardy theme song here). How many were you able to come up with? Now, name all of the words you can in which K is the third letter. How many could you name this time?

If you are like most people, you found it easier to generate a list of words that begin with K; the words probably came to you more quickly and were more plentiful in number. But, did you know that there are three times as many words in which K is the third letter than there are that start with K? If that’s the case, why is it so much easier to create a list of words that start with K?

5.9.13_Crosby_BeFiBlog_1_pic3It turns out that our mind’s retrieval process is far from perfect, and a number of biases play into our ability to retrieve data with which we’ll make a decision. Psychologists call this fallibility in your memory retrieval mechanism the “availability heuristic,” which simply means that we predict the likelihood of an event based on things we can easily call to mind. Unfortunately for us, the imperfections of the availability heuristic are hard at work as we attempt to gauge the riskiness of different decisions, including how to allocate our assets.

In addition to having a memory better suited to recall things at the beginning and the end of a list, we are also better able to envision things that are scary. I know this first hand. Roughly six years ago, I moved to the North Shore of Hawaii along with my wife for a six-month internship. Although our lodging was humble, we were thrilled to be together in paradise and eager to immerse ourselves in the local culture and all the natural beauty it had to offer. That is, until I watched “Shark Week.”

5.9.13_Crosby_BeFiBlog_1_pic5For the uninitiated, “Shark Week” is the Discovery Channel’s seven-day documentary programming binge featuring all things finned and scary. A typical program begins by detailing sharks’ predatory powers, refined over eons of evolution, as they are brought to bear on the lives of some unlucky surfers. As the show nears its end, the narrator typically makes the requisite plea for appreciating these noble beasts, a message that has inevitably been over-ridden by the previous 60 minutes of fear mongering.

For one week straight, I sat transfixed by the accounts of one-legged surfers undeterred by their ill fortune (“Gotta get back on the board, dude”) and waders who had narrowly escaped with their lives. Heretofore an excellent swimmer and ocean lover, I resolved at the end of that week that I would not set foot in Hawaiian waters. And indeed I did not. So traumatized was I by the availability of bad news that I found myself unable to muster the courage to snorkel, dive or do any of the other activities I had so looked forward to just a week ago.

In reality, the chance of a shark attacking me was virtually nonexistent. The odds of me getting away with murder (about 1 in 2), being made a Saint (about 1 in 20 million) and having my pajamas catch fire (about 1 in 30 million), were all exponentially greater than me being bitten by a shark (about 1 in 300 million). My perception of risk was warped wildly by my choice to watch a program that played on human fear for ratings and my actions played out accordingly. This, my friends, is heuristic decision making hard at work.

Hopefully by now the application to investment decision-making is becoming apparent. For so long, we have been sold an economic model that posited that we had perfect, uniform access to information and made decisions that weighed that information objectively. In reality, our storage and retrieval processes are imperfect, with recent and emotionally charged pieces of data looming larger than the rest.

5.9.13_Crosby_BeFiBlog_1_pic4Investors and financial services professionals that understand these imperfections are better positioned to understand the limitations of their knowledge and try to intervene accordingly. At times this may mean taking a more tentative position to circumvent undue risk. Other times this may mean digging a little deeper on what may initially appear to be a foolproof trade. Whatever the case, it is only after we free ourselves from the myth of homo-economicus, that we are able truly become our best investing selves. Making decisions based on subjective logic needn’t be your undoing as an investor, but assuming that you’re a perfectly logical decision maker just might.