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Why We Do Stupid Things With Money: A Three-Part Crash Course in Behavioral Finance - Part III

January 18, 2021

Part III

The Informed Investor

By simply being aware of our own potentially flawed thinking and vulnerability to emotional biases, we can check ourselves in real time to see if we might be on the verge of a poor decision. However, I suggest you do some legwork to set yourself up for success.

Know Yourself

Do a bit of introspection. Looking at the short list above, do you think you are vulnerable to any of these biases or cognitive errors? Consider past mistakes; what might have driven your behavior when you made those mistakes? If you understand your own vulnerabilities, you are much better equipped to catch yourself.

For example, I know for a fact that spending money is one of my very favorite things to do. But if I spend it all, I can't save or invest for the future.[1] Since I know this about myself, I've put safeguards in place to stop myself from spending all of what I earn. I pay myself first through 401(k) deferrals, follow a budget, and monitor spending on a weekly basis. Even professionals are human.

Have a Plan

If you have a plan in place already, there are fewer decisions to make in real time. Fewer decisions mean fewer chances to make a mistake. A plan will also be your comfort in tough markets. You can ride through a bad market if you know that you already accounted for that situation in your plan. Lastly, having a plan allows you to maintain a long-term mindset, which will give you more time and space to consider decisions before you make them. A well-considered decision is likely more sound than one made in haste under stress.

Cultivate Discipline

Along with having a financial plan, have rules in place for how you'll invest. Make sure those rules are easy to implement and based on solid reasoning. For example, your rules might include:

  1. Stick to an 80% stock and 20% bond allocation (or the allocation that best fits your Risk Tolerance).
  2. Review accounts semi-annually to make sure investments are still allocated properly; rebalance if needed.
  3. Aim to own mutual funds with internal expenses of 1% or below.
  4. Aim to own mutual funds with a 4-star Morningstar rating or better.
  5. Invest a set dollar amount every month/quarter/year regardless of which direction the market is going.

These rules may not work for everyone, but they should give you an idea of what dispassionate, rules-based investing might look like for you.

Form the Right Team

By now you may be thinking, “I do not have time for this! I've got so much on my plate right now.” I get it. Investing isn't rocket science, but it can be time-consuming, and many of us have very full lives. I certainly don't DIY every task that living my life requires. If the thought of running your portfolio as described above makes your want to hide under the covers or bores you to death, maybe the right choice is hiring a Financial Advisor. A good Financial Advisor will help you clarify your goals; understand your needs, quirks, and biases; and build a plan and portfolio that serve you.

Being a modern human in a modern world with an outdated operating system means that good decision-making isn't always easy. But it's also not impossible. Know yourself, have a plan, have some rules, and hire a good Financial Advisor if you need one. You can do this. I can help.

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Behavior Finance and Wealth Management by Michael Pompain was a primary reference for this series. Some fact checking and light edits were kindly provided by PWM Market Strategist Michael Antonelli. Mike has his own excellent blog at Bull & Baird. Go check it out!

[1] We call this Self-Control Bias.