Irrational financial practices (spending too much, saving too little, lack of financial discipline, etc) are what prevent most high-income earners from finding financial success. On the outside, it seems that we lack the motivation, self-control, and determination to save enough money and to prepare for the future.
Yet, it’s not that simple.
These traits our hard-wired into our brains. And that is exactly what the field of behavioral economics (or behavioral finance) seeks to understand. Why do we make bad financial decisions?
Over the next several weeks, I will be publishing articles on what I am calling The Behavioral Finance Series (BFS). You can read all of the BFS posts here. Each post in the BFS will look into a specific bias, describe how it impacts our financial decisions, and how we can defeat that bias to become better investors and stewards with our money.
It will probably help you become a better doctor, too.
Introduction to The Behavioral Finance Series
This series is not for the faint of heart. Our hard-wired brains are constantly trying to protect us from situations our predecessors faced. Yet, many of these tendencies lead to really bad decisions in modern day situations.
Let’s look at a few examples so that you can get a taste of what is coming in the BFS.
Eat When You Can
Before the modern age, our ancestors were taught time and again that the next meal might not come. For this reason, they devoured whatever was put in front of them whenever and wherever they could.
There is a similar philosophy in medical training. You may have heard that the first rule of surgery is:
“Eat when you can. Sleep when you can. And don’t mess with the pancreas.”
For those of us who do not work in the operating room, we might not have the chance to damage the pancreas with a scapel. However, the wisdom of the first two parts of this rule are self-evident to anyone who has gone through medical training.
In residency, you must eat when you can. And sleep when you can.
While these behaviors served as a great help in those times, these same traits now lead to some terrible financial decisions. We still tend to consume anything that is put in front of us. Immediately.
This includes our paychecks, and explains why many doctors (and humans) fail to save money.
It also explains why those who learn to save automatically (i.e. they schedule their investments each month) often build wealth much faster. By sending part of their paycheck towards retirement savings before they see the money in their bank account, they avoid the “eat when you can” mentality.
If you ever wonder why you can’t save money, this is a good place to start. (Or you can read my top-rated book that I wrote on The 20% of Personal Finance Doctors Need to Know to Get 80% of the Results)
Patterns in the Clouds
For example, noting when food might be more plentiful (summer/spring) and when it might be more scarce (winter) led to life-saving harvesting measures. Those that didn’t figure this out often didn’t survive.
In the same way, if they didn’t learn which plants and creatures were friendly – and which were not – this had an impact on their survival rates. Eating a poisonous plant (or getting bitten by a poisonous snake) was a sure-fire way to get sick or die.
Pattern recognition was key.
Some of these skills still provide great value to this day. But our ability to recognize patterns can also lead to great harm when it comes to our finances.
For example, though technical analysis usually doesn’t work, we are still drawn to the TV analysts who clam that they have the secret to decoding the stock market trends. Our eyes still search for patterns that may or may not exist in the market (was that a “head and shoulders” or was it a “double top and bottom?)
People claim to know when the market is trending up or down. We might believe them until the next day when we see that the markets did the opposite.
Whether reading tea-leaves or seeing shapes in the clouds, pattern recognition is hard-wired in humanity. When it comes to money, this isn’t always helpful. In fact, it usually causes us to do stupid things with our money (like buying when the market is high and selling when it is low).
In the 1970’s, Amos Tversky and Daniel Kahneman asked radiologists how they diagnosed stomach cancer. The radiologists told them that there were seven criteria that were used to make the diagnosis. They then performed a study comparing radiologists to an algorithm.
During this study, they threw a curve ball. They showed the radiologists several images. And, during these images they would repeat some of the images later on.
Using this method, they found that the algorithm not only outperformed the radiologists, because they would not strictly follow their own criteria. They also found that the radiologist gave a different diagnosis when provided the same exact image later on. Of course, the doctors didn’t recognize it was the same image.
Either way, their irrational and unpredictable nature was shown in the study findings.
I am sure that the radiologists did what every attending does. “Well, I normally follow the criteria… but in this specific case, I don’t think this particular criteria is as important as the others.”
If we are being honest, we all practice medicine a certain way based on our experiences. This is particularly true when we have a bad patient outcome that scars us. “I am NEVER doing that again…”
You can see how this would lead to inconsistent practice, and how studies like this one pointed the medical field into the “evidence-based” medical practice we aim for today.
The Behavioral Finance Series Structure
Our tendency towards an irrational nature and our biases can impact our decisions.
Whether diagnosing cancer or deciding how to invest your paycheck – we must understand that we are biased and often make decisions that are not backed by evidence.
Hopefully, the examples above got you thinking a little bit about the “why” behind your decision making processes.
Here is what you can expect going forward from this series.
In each post, we will walk through three key pieces:
- An interesting example that shows our irrational thought processes, biases, and tendencies.
- How this bias impacts our decisions with money.
- We will discuss how we can be more aware of that bias and set up a system to help prevent it from wreaking havoc in our personal finances.
This series aims to teach you how to spend less, save more, and make the most of the resources you have earned.
If you are certain of your ways, and have no interest in learning more about what makes you click – then this behavioral finance series will not be for you.
However, if you are willing to be open-minded, you might learn a thing or two that will prevent you from making catastrophic financial mistakes. It might also make you a better doctor, too.
What do you think of the examples provided in this post? Have you noticed these human tendencies in your thought processes? Have they ever led you to make good/bad financial decisions? Leave a comment.