Human beings are funny. We are amazing creatures with incredible capacities but at the same time we often unwittingly repeat the same mistakes over and over again, and these mistakes can be costly to our well being.
Bias is often a contributing factor to these mistakes. Bias often forms out of personal experience and the perceived outcomes that arise from our actions and decisions. In fact, this is regularly referred to as “outcome bias”. So when we alter our behaviour as a result of a recent outcome or event, how do we know if we are really learning from our experiences or are just falling prey to unfounded bias?
Healthy Biases – A Personal Example
By way of a personal example, I have a strong bias against cougars (also known as mountain lions). I spent many years on Vancouver Island, in British Columbia, which has a substantial population of these things, and I am quite familiar with them. They are sneaky fiends who will silently stalk you through the forest for a ridiculously long period of time before deciding to jump on your back when you are not looking and sink their teeth into your neck. Being on the Island, you get used to seeing the odd newspaper article recounting some hapless resident who ended up taking a one-way walk in the woods. Of course, the vast majority of people who encounter a cougar don’t end up like this, but enough do that I prefer to keep them away from me.
The reason I recount this is that it is an example of a reasonably healthy bias. Although I am sure there are many who characterize it as unfair (which is a part of the very definition of bias), it’s based on accurate knowledge of the subject. It also embraces a rational assessment of the potential negative effects that the bias is designed to protect me from. In that light, I continue to embrace it, as in my balanced view of the topic there is greater benefit to maintaining the bias (it causes me to avoid situations where I may encounter a cougar and end up being it’s lunch) than in abandoning it. In short, the risk/reward trade-off is such that this bias makes sense.
Unhealthy Biases And Your Finances
What about less healthy biases? And what does all this have to do with a person’s finances? Let’s look at another example.
In my financial planning practice, particularly in the later years, I had a lot of conversations with new clients that went something like this: “I invested in the stock market once. I lost a whole lot of money. The stock market is a ripoff. I learned my lesson and I will never do it again. I have had my money in term deposits ever since.”
Invariably, on further discussion, I would find out that this person invested sometime after the year 2000, took a hit in the 2008 recession and pulled all of his or her money out of the market.
So, did this person really “learn from their mistake”? Or is something else going on here? How can we tell?
Bias Or Learned From Experience – How To Tell The Difference
There are three factors we can look at to determine if the example above is the formation of an unreasonable bias or a rational opinion derived from experience:
1) Have other people had different outcomes despite making the same decision or taking the same course of action?
If the cause of a person losing a significant amount of money was their decision to invest in stocks, then everyone else investing in stocks must have had the same or a similar unsatisfactory outcome.
However, if others were invested in stocks during the same period but had outcomes that were satisfactory and they stayed invested, then that conclusion must be at least partly incorrect. There must be other factors that had a bearing on the outcome.
2) Have all the factors that could have a bearing on the outcome been considered?
This is really an issue of knowledge. Most of the clients who made similar statements about their experience investing in stocks were either new investors, or were investors that had very little knowledge of investing. In many cases they were in the habit of not reading their own statements until, of course, they saw bad news in the press.
If you are drawing conclusions from the outcome of an action or decision, you need to assess whether you have sufficient knowledge of the issue and adequate access to information to fully grasp all of the variables that may have influenced the outcome. In this case, was it really the decision to invest in stocks that was the failure point? Or could it have been an issue with the timing of purchases or withdrawals? Could it have been poor stock or sector selection? A lack of diversification? A failure to match the investment to an appropriate time horizon?
3) Have I accurately identified the risk/reward trade-off involved in the original decision?
Once you have an understanding of outcomes experienced by others, and you have put effort into understanding all the variables that may have influenced the outcome of a decision (whether good or bad), you are now much better able to assess the real risk/reward trade-off inherent in that original decision. This gives you a much better foundation for assessing a future course of action.
In the case of our example, my goal was always to get the client to understand that if they had stayed the course with their investment (not pulling out at the bottom of the market) they would have been better off in the long term. I also would help them to appreciate any errors in the portfolio that could have contributed to under performance, such as a concentration on too few holdings, a lack of sector diversification, or a portfolio that was simply subject to more volatility than they could handle.
Ideally, this left the client with a better understanding of the function of volatility in a portfolio (risk) and a better understanding of the potential to improve investment returns (reward) by being appropriately invested. With this clearer understanding of the risk/reward trade-off the client could hopefully make a better decision on their future course of action, rather than just reflexively falling back on the bias that was spawned from their earlier experience.
Wrapping It Up – Make Better Decisions Through Better Learning
At the end of the day, what we are really talking about here is developing the skills necessary to accurately assess the outcomes of decisions we make. Rather than having a knee-jerk reaction of deeming a decision good or bad based solely on a known outcome (outcome bias), take the time to:
1) Talk to others who have made similar decisions – what was their experience?
2) Educate yourself – do I understand all the factors that led to this outcome and how the outcome may have been different if one of those factors had changed? Seek out subject-matter experts to expand your knowledge.
3) Understand risk/reward trade-offs – just because you made a decision and it worked out, doesn’t mean the decision was a sound one. Maybe you just got lucky and that luck will not be repeated. Similarly, if it turned out poorly, maybe the decision was a sound one but was impacted by other factors that could be mitigated next time. Make sure you understand the risk/reward trade-off attached to any course of action and be sure you are comfortable with it.
Good decision-making skills apply to all areas of your life. Decisions about where you work, where you live, what you drive, having a family….the list goes on and on. Make sure you are making the best decisions possible by effectively leveraging your previous experience and not allowing yourself to be driven by unfounded bias.
Important Disclaimer: the information above is for general informational purposes only and does not in any way constitute an offer for the purchase or sale of any security and is not intended to be considered comprehensive or personalized financial or investment advice. themoneygeek.info assumes no responsibility for the use or application of this information. Always consult a tax, investment, or other appropriate professional before adopting any new financial strategies.
I am an accredited Financial Planner with 23 years of experience in the financial services industry. During the course of my career I completed hundreds of financial plans and recommended and sold hundreds of millions of dollars of investment products. I believe that financial independence is a goal anyone can aspire to and I am passionate about helping others to live life on their own terms.