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Q&A: Dan Heath and Mark Riepe on Behavioral Finance

How does someone who’s devoted years to studying the flaws and biases in human decision-making apply what he’s learned to his own finances? Dan Heath, who’s co-authored four books steeped in psychology, discusses his approach with Mark Riepe, head of the Schwab Center for Financial Research and co-author, with Nobel Prize–winning economist Daniel Kahneman, of “Aspects of Investor Psychology: Beliefs, Preferences, and Biases Investment Advisors Should Know About.”1

Mark: In your books, you make the point that it’s not enough to simply understand behavioral biases. People need to learn how to change behavior and avoid the pitfalls our minds can lead us into.

Dan: Being aware of your own behavioral biases is about as effective as being aware that you’re nearsighted. To see better, you need a pair of glasses, and to make better decisions, you need a process.

Let me give you an example from my own experience. I’m pretty ignorant about the stock market, but because I have an MBA from Harvard I’m also prone to overconfidence. So what I do is faithfully follow an investment portfolio developed by David Swensen, the longtime manager of Yale’s endowment. It’s a very meat-and-potatoes portfolio—stocks, U.S. Treasuries, REITs and some inflation-protected securities. It makes my investing very simple; I just rebalance from time to time. And that way I know that I’m not going to fall victim to my own hubris.

Mark: At Charles Schwab, we have seven investing principles. Number one is establish a plan. Number seven is ignore the noise and stick to your plan. That seems to be what you’re saying.

Dan: I mean, you don’t need a decision-making process for what you’re going to eat for lunch, but for decisions that really matter—that affect your family or your job or your wallet—you need a plan.

Mark: For investors, there’s no shortage of contrary opinions: The economy’s doing great; the economy’s doing poorly. Tech stocks are overvalued; tech stocks are undervalued …

Dan: Like a lot of investors, I can get paralyzed by the kind of financial news you’re describing. I read that the economy is coming to a crashing halt—and I get scared. I read that things have never been better—and I’m back to being confident. But what I’m describing is another behavioral trap: making decisions based on short-term emotion. When it comes to personal finance, the game is often won or lost on emotion—which is another reason to get out of the business of predicting the market and just stick to a strategy. Or at least that’s what I do.

Mark: That’s right. If you’re watching monthly returns and there’s a drop of 10%, it feels like the end of the world. But if you define success as how your wealth has grown over the past decade and whether you’re making progress toward your goals, things look very different. Right now, for example, the stock market is up several hundred percent from its 2009 low during the financial crisis. Suddenly, a bad month or even a bad year doesn’t look nearly as significant.

Dan: Ultimately, investors have to find their own solutions for insulating themselves from the panic (at the bottom of the market) and overconfidence (at the top) that lead us to make dumb decisions. For some, that means a financial advisor. It’s funny: Some people think that what they’re getting with a financial advisor is some kind of wizardry with respect to picking a portfolio. But what’s of even greater value is the financial advisor’s role as an emotional shock absorber.

Mark: Whether you get advice from a financial advisor or from a trusted friend who knows something about investing, I think the first goal is to find someone who can help you establish a plan. With a plan in hand, he or she can then also help you keep short-term emotions in check. They can help you step back and ask, 'Is there anything going on in the market of a magnitude that would cause me to alter my plan?' Usually, the answer is no.

Dan: That’s interesting, because what you’re getting at applies not just to investing decisions but also to the decisions you make across your life. Ideally, you want a process you can trust that ensures you’re considering the right information—and not just acting on emotion—no matter what decision you’re making. We can’t control the outcomes. We’ll win some and lose some. But we can be confident that we did everything we could to make the right call in the moment.

1The Journal of Portfolio Management, 1998.

What You Can Do Next

Getting a second opinion can help you make sure you’re not just acting on emotion. See all the ways Schwab can help.

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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Investing involves risk, including loss of principal. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Past performance is no guarantee of future results.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a nonretirement account, taxable events may be created that may affect your tax liability.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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