Decision making part 1:How we make decisions

The difference between who you are and who you want to be lies in what you decide to do
— Bill Phillips

Introduction

It seems nowadays we are inundated with options. Hundreds of TV channels, online clothing stores and many investment options. Even once we have finally chosen on a mortgage provider for example, then we have another set of decisions. Do we fix? Do we float? Both? Revolving credit? Interest only? Decisions within the decision if you will. This may seem like a good thing on the surface. More options mean more competition for our attention, which should result in a greater quality of product or service at a lower price.

However, the end result can make us tired of thinking and analysing, and potentially making a sub par decision. Or no decision at all. Bear in mind that the choice to make no decision is still a decision. Paralysis by analysis is a saying that refers to having so many options that we end up not choosing anything, or choosing something that was not the best choice.

We have two interconnected, yet distinct systems for processing information and arriving at decisions. The automatic system, which operates quickly, effortlessly and unconsciously. Under this system we may even act before even knowing what caused us to act. Daily habits fall under this system. The second is the reflective system, which is driven by logic and reason. Under this system we are more aware of our decisions. A quick decision whether or not to cross the road will use the automatic system. The complex decision to buy a house will use the reflective system for most.

 

What does this have to do with money?

You may be asking how this relates to personal finance. It has everything to do with money. Every day we make choices about where our money goes and how it is spent. With investing alone we have the choice of bank, bonds, shares, property, gold and commodities to name a few. Within each of these categories we have many more decisions to make. Shares for example, we can purchase individual stocks, futures, small cap, mid cap, large cap, value, growth, local or international. Or will you save for a vacation or a new car?

As a non-coffee drinker I feel like I need a college degree for all the options, I just give up trying. The Starbucks menu is so big it can be seen from outer space. This is what is meant by paralysis by analysis. The plethora of information and options is designed to make us confused and make impulse purchases or purchases that we don’t fully understand.

 

Know your goals and educate yourself

Decision-making or lack thereof is the cornerstone of getting where we need to go in life. One example is budgeting. For someone that has been frugally supermarket shopping for a long time, any future decision to keep doing so becomes automatic. Whereas, someone just starting out will require much more thought processing and effort with regards to where best to shop, what time of day, what brands, what quantities etc. With knowledge, education and effort comes automation through habit formation. When someone is on auto-pilot it means that they are in full control which comes from mastering our craft. This helps explain why we often give up on things so early on because it is difficult and time consuming to make changes. 

Another example of automatic may be buying a daily lunch. Buying a lunch may be someone’s default – making the purchase without even thinking about it. It is fine to have some decisions like this on automatic, but the more automatic purchasing decisions we are making that are not in line with our financial goals the more troublesome our financial situation will become, leading to a life of regret. “If only I saved those little amounts”. You may be thinking, “I work damn hard and I’m going to eat and drink as I please”. That is fine and I don’t begrudge that. It only becomes a problem if the purchases don’t help you reach your goals such as travel or saving for retirement. Sometimes we need to step back and consciously make the unconscious, conscious. Look at how small purchases can affect future income in this article on compound interest. 

The key distinction to be made here is decisions that used to be reflective but are now automatic, are good. Automatic decisions that have never been reflective may deserve some attention if they are preventing you from reaching your goals.

 

How do we make automatic decisions? Heuristics of course!

What are heuristics I hear you say? Glad you asked. It is a fancy pants word for mental shortcuts. Feel free to use it to impress at your next dinner party.

As evolved human beings we are always looking for shortcuts to get to our final destination. Decision-making is no different. These shortcuts are known in the field of psychology as heuristics. They are personal biases that help with the laboursome, stressful and tiresome reflective decision-making process. We can’t think of every option on every decision. We would never get anything done. It then becomes necessary to rely on mental shortcuts that allow us to act quickly. Heuristics are how two people with the same information can reach different conclusions.

Common heuristics include, but are not limited to:

  • Overconfidence
  • Hindsight
  • Availability
  • Confirmation
  • Self-serving

We will go over an example for each in the context of personal finance.

Overconfidence bias
I am confident that my favourite league team, the Warrior’s, are going to win every game before they take the field. This is a classic example of being overconfident as their winning record is only about 45%. In this instance the overconfidence hasn’t caused a lot of harm. Yes, I am disappointed when they lose, but at least I still have my health and wealth. However, in the stock market, we so often over-estimate our ability to pick winning stocks, resulting in unexpected losses. This would affect our wealth and quite possibly our health too.

In a study by Nassim Taleb, 84% of Frenchman estimated that they are above average lovers. However 50% is the median and only 50% should be better than average statistically. This discrepancy of 34% is the overconfidence factor. As I’m sure all the women around the world already know, men are more prone to the overconfidence bias than women. This may explain the not asking for directions when lost thing when driving!

As you can imagine, when it comes to investing our money this can be a very significant bias with damaging results if not aware. Tip: If you suffer this bias look for information that disconfirms your beliefs. This should help to bring confidence levels more in line with reality.

Hindsight bias
We all know the ‘know-it-all’ who makes it known to everyone that they knew something would happen. However, they didn’t make their thoughts known until after the fact. The problem is we didn’t know all along, We only thought we did. This bias is dangerous in that we are not learning because we are not stopping to ask ourselves why something happened, leaving us feeling overconfident and feeding into that bias too. This bias is used because we like to feel like we are in control of things that happen around us. By convincing ourselves we knew all along it helps us make sense of the world and why things happen.

Availability bias
This is when related events spring to mind when making a decision. For example, when the stock market plunged in 2008 a lot of investors would have got burned. Even though 2008/09 would have been a great time to buy cheap value stocks, many would have stayed well clear because the most available memory they had was one of loss. Thus missing out on some serious gains. People who weren’t invested in 2008 would have been more likely to invest in 2009 as they didn’t experience the same pain. We often jump to conclusions by using the information right in front of us whilst failing to consider the information that is just offstage. This heuristic operates under the principle of, “if you can think of it, it must be important”. After watching Jaws for example, you are probably less likely to want to go for a dip in the ocean. Even though you are more likely to die on the drive home. Such a grim example….moving right along.

Confirmation bias
We tend to seek information that confirms our pre-existing ideas and beliefs. If someone believes that renting a house is better than buying a house they will seek information to support this, whilst ignoring information that contradicts this belief and vice versa.

Self-serving bias
This is a very common bias where we tend to attribute successes to things we did, and failures to things outside our control. Similar to the hindsight bias, this results in not learning from our mistakes and overconfidence. If for example, you pick a stock and then it goes up in price by 50%. You then proclaim to anyone that will listen that you studied the company and believed in the product potential and that your in depth analysis was the reason you did so well. Now, if this stock were to go down 20%, you are much more likely to blame economic conditions or political factors, instead of your own analysis.

 

Final Thoughts

The point of the article is to point out that we do have mental shortcuts and we may not even realise. The more we are aware of our biases and their limitations, the more we can be aware of the consequences. If we are not aware, as shown above, there can be severe financial consequences. Remember, it only takes one second to make a bad decision.

As you can see heuristics are a great time saver. Consider a simple pair of jeans. What used to be a straight forward purchase 15 years ago, we are now faced with washed, unwashed, skinny, low rise, boot cut, relaxed, slim fit, straight cut. We then have the decision of which shop to buy from. Also consider the choice of crackers in a supermarket. We have salted, unsalted, different shapes and sizes, different flavours, gluten free, different prices, a range of fat content and so on. There are hundreds of varieties to choose from. Without the use of heuristics we would be spending all our days making relatively simple decisions. Most of the time our own judgments and biases will be correct and serve us well.

Now, more than ever, we need and rely on shortcuts. There are just too many options to consider everything all the time. Compared with 20 years ago there is more of everything – more supermarkets, more investment firms, more shops, more internet, more tradespeople, more, more, more. The best thing we can do for ourselves is to take a step back and simplify our lives and our decisions to the things that really matter. Then if we make bad decisions on the things that don’t, it doesn’t matter. Otherwise, we will either lose efficiency in what we are doing, or burnout. Or both. For me, my list of priorities includes family, friends, meaningful work, health, personal finance and continued learning. Any decisions that don’t affect these core values of mine don’t get much attention.

The more decisions we make with our goals in mind, the fewer mistakes we can make. And we will be living the life we want which will no doubt result in good health, wealth and happiness.

In my next blog article I will be continuing on from this theme of decision making and discuss why we may have certain heuristics and what we can do to overcome their limitations.

 

 

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here.

 

Please leave your comments below………how have taking mental shortcuts in your decision making helped or harmed you? What daily things do you do without even thinking about?