Jonathan Clements | October 15, 2016
IF YOU DROVE drunk but got home unscathed, you wouldn’t wake up the next morning and think, “I guess it’s okay to get behind the wheel after 13 beers.” Yet, when handling our finances, we do that all the time.
“Markets generate a lot of data, but they don’t generate a lot of clear feedback,” writes academic Terrance Odean in his foreword to Michael Ervolini’s thoughtful book, Managing Equity Portfolios. “Outcomes are noisy. Good decisions may have bad outcomes. Bad decisions may have good outcomes.”
The problem: We typically judge our financial choices by a single, crude yardstick—whether they make or lose us money. But that measure of success or failure can result in faulty feedback that validates bad behavior. Consider three examples:
- We bet everything on a single stock and it soars in value. We imagine we’re great investors. But in all likelihood, it was dumb luck—and our next big bet could wipe us out.
- We don’t bother with homeowner’s insurance, saving roughly $1,000 a year in premiums. Our home hasn’t burned down, so it seems like a wise decision—until we smell smoke wafting up from the basement.
- We dump bonds and foreign shares, because they’ve posted seven years of mostly lackluster returns. Instead, we make a big, undiversified bet on highflying U.S. shares. The market cycle turns—and you can guess the rest.
What’s the lesson here? Dispassionate contemplation is a better teacher than personal experience—because contemplation leads us to consider the range of possible outcomes, while our personal experience represents a sample of one. So what happens if we consider the range of possible outcomes? We become focused not on whether a particular strategy has made us money in the past, but on how to improve the odds that we’ll make money in the future.
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