It’s not always easy to make good decisions. We’re often quick to abandon our plans when impulse strikes. We fear losses more than we value gains. Our view of the future is hopelessly colored by the past.
Such biases can get in the way of our best interests—not least when we’re trying to manage our finances. And the effects can be costly.
Fortunately, behavioral scientists are on the case. Meet Katy Milkman, a professor of operations, information and decisions at the Wharton School of the University of Pennsylvania and the host of Schwab’s Choiceology podcast. Her work not only exposes and explains the kinds of biases that can cloud our decision-making—it also gives us tools we can use to combat them.
We asked Katy to identify some effective tips investors can use to fortify their decision-making. Here’s what she told us.
Make decisions at your most rational
Self-restraint doesn’t always come naturally, especially when temptation is staring us in the face. We eat dessert we know isn’t good for us. We turn on the TV instead of hitting the gym. We spend money we should save.
Behavioral scientists call this present bias—the tendency to gratify an immediate desire today at the expense of a potentially much larger reward tomorrow.
So what’s the best way to keep it under control? “The key is not to make important decisions too close to when they’ll take effect,” Katy says.
Say you’re planning a big dinner out with your spouse and a group of friends but don’t want to go off your diet. The night before, look at the menu online, choose a healthy option and tell your spouse what you’re planning to order. At the restaurant, don’t even look at the menu and encourage your spouse to help reinforce the decision you made ahead of time.
“Shifting decision-making to a moment when your most rational self is running the show can be very effective,” Katy says.
Katy says another way to fight present bias is to use a so-called commitment device to help keep yourself focused on a goal—say, by agreeing to forfeit money if you fail to follow through on a plan. If your goal is to put a certain sum of money into an emergency fund each month, for example, commit to forfeiting an additional sum of money to charity should you miss your target.
There are websites that facilitate such monetary commitments, but a friendly side bet with a co-worker or spouse can serve the same purpose.
Reframe your gains and losses
A large body of research has shown that people are far more motivated to avoid a loss than they are to rack up an equally large gain. Behavioral scientists call this loss aversion, and it’s a real bugbear for investors.
Katy explains it this way: “Finding a $20 bill on the way to work would probably make you feel pretty good. But how would you feel if you turned around and lost it later in the day? Research tells us you’d be twice as unhappy about the loss as you were happy from the gain.”1
In another example, researchers found that charging shoppers 5 cents per disposable bag cut their use roughly in half, whereas paying them 5 cents per reusable bag had virtually no effect at all.2 In other words, the threat of losing a nickel proved more motivating than the prospect of gaining one.
Loss aversion can also affect the way we invest. For example, research has shown that we’re far more likely to sell a winning stock than a losing one because we’re eager to realize a gain and reluctant to lock in a loss.
People make poor intuitive statisticians, which can lead to erroneous assumptions, Katy says.
Consider the probability that, in a set of randomly selected people, two of them will have the same birthday. You can be 100% certain that in a group of 367 people, at least two of them will share a birthday, because there are only 366 possible birthdays (including February 29). “However—counterintuitive as it may seem—there’s a 99.9% probability with just 70 people and a 50% probability with just 23 people,” Katy says.
Our trouble assessing probabilities can skew the way we gauge our performance as investors.Say you buy a handful of individual stocks and find that, after three years, they’ve all outperformed the broader market. While it may be tempting to conclude you have a gift for picking equities, you might also have gotten lucky.
“Until proven otherwise, don’t believe it’s anything but chance,” Katy cautions. “It’s easy to be blinded by your successes, which is why it’s so important to have an objective way to assess your outcomes.”
Although there are some behavioral biases for which researchers have developed solutions, there are many more that still pose challenges, Katy says. “The goal of my work is to figure out what regular people can do to overcome these pitfalls, and Schwab’s Choiceology podcast is meant to help investors do just that.”
1Amos Tversky and Daniel Kahneman, “Advances in Prospect Theory: Cumulative Representation of Uncertainty,” Journal of Risk and Uncertainty, 1992.
2Tatiana A. Homonoff, “Can Small Incentives Have Large Effects? The Impact of Taxes Versus Bonuses on Disposable Bag Use,” American Economic Journal, 11/2018.