How to Make Better Financial Decisions

Upbeat music plays throughout.

On-Screen Text: Michael Kealy, Education Coach

Narrator: The brain is a machine that automatically processes information. While this fast-processing power enables us to make decisions, sometimes these decisions are made so quickly that the brain bypasses logical decision-making.

In the behavioral economics book, Nudge, Richard Thaler and Cass Sunstein explore how our brains process information.

In the book, readers are presented with two tables and asked which one is narrower.

Animation: Graphic appears showing an optical illusion where one image appears to be a different size than another.

Narrator: You might guess that the table on the left is narrower, but in fact, they're identical in size. Their different orientations trick your eyes into perceiving differences that aren't there.

In the past, having vision highly attuned to differences may have had evolutionary benefits—like discerning an edible berry from a poisonous berry. But this benefit also left us vulnerable to optical illusions.

In a similar way, our hardwired processing and emotional reactions help us make quick decisions. But these mental shortcuts can also lead to errors in judgment called cognitive biases. And cognitive biases can sometimes cause investors to make irrational financial decisions.

For example, here's a coin toss. If it's heads, you lose $100. If it's tails, you'll win $150. Would you accept the gamble?

A perfectly rational person would take this risk because the reward is higher than the risk. But people are afraid of losing money.

This type of irrational thinking is influenced by a cognitive bias called loss aversion, an effect first noticed by psychologists Daniel Kahneman and Amos Tversky.

This loss aversion could potentially hurt an otherwise rational investor.

Animation: S&P 500 annual total returns chart from 2002 to 2021

On-screen Disclosure: Source: Schwab Center for Financial Research. Returns assume reinvestment of dividends. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. For additional information, please see Schwab.com/IndexDefinitions. Past performance is no guarantee of future results.

Narrator: For example, in 2008, the average annual return for the S&P 500^® was negative 37%. When faced with such a huge drop, some investors may have been tempted to exit the market to avoid loss.

However, the average annualized return from 2002 to 2021 was actually closer to 10%.

Animation: Value of $100,00 invested in stock market from 2007 to 2020

Animation: Chart comparing the performance of two investors: one who kept their $100,000 invested in stocks through the 2008 crash, and one who pulled out and didn't begin investing again until 2010. The investor who stayed invested ended 2019 with $299,780, while the investor who pulled out ended 2019 with only $195,315.

Narrator: The loss-averse investor who exits the market during a negative year in an attempt to avoid more losses will likely miss out on long-term gains. Even if these investors enter the market again after a downturn, they may not be able to catch up to the investor who stayed invested.

Some investors may also fall prey to hyperbolic discounting, which is a fancy economist way of saying people often prefer immediate but smaller rewards over larger long-term rewards.

This preference for immediate rewards could prevent people from saving money and investing. For some people, it's more tempting to spend the extra $100 in their pockets today than wait for compound interest to potentially grow that money over time.

These types of cognitive biases are part of being human. To help, there are some strategies you can use.

One way to avoid hyperbolic discounting and save more is by setting up automatic contributions to your accounts.

Animation: Value of $100,00 invested in stock market from 2007 to 2020

Animation: Chart comparing the performance of two investors: one who kept their $100,000 invested in stocks through the 2008 crash, and one who pulled out and didn't begin investing again until 2010. The investor who stayed invested ended 2019 with $299,780, while the investor who pulled out ended 2019 with only $195,315.

Narrator: And to curb loss aversion, focus on long-term results to avoid exiting the market too early.

A systematic plan with a predefined timeline for rebalancing and withdrawing can help you stay focused on long-term goals and take psychology and emotions out of the equation.

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