Is your financial thinking distorted?
The human brain is a wonderful thing, but sometimes we suffer from what psychologists call “cognitive distortions.” Cognitive distortions cause us to perceive the world inaccurately. When we act on these distorted perceptions, we make poor decisions and undermine our own happiness.
Cognitive distortions can also undermine our financial success. In fact, legendary investor Warren Buffet may have been referring to cognitive distortions when he shared the secret to successful investing. He said, “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” The good news about cognitive distortions is that they can be corrected.
A common cognitive distortion is known as “catastrophizing.” We’ve all known people who see disaster looming around every corner. They exaggerate bad news and carry it to its logical—often catastrophic—extreme.
For investors who catastrophize, every market downturn is the beginning of a market meltdown. Fearing the worst, they sell their investments at the slightest sign of weakness. Because they cannot maintain their convictions they often end up buying high and selling low.
If you find yourself catastrophizing with your investments, you can work to overcome it by reminding yourself that markets ebb and flow like many natural systems. Think about ocean tides. We don’t panic when the tide is going out, fearing that somehow the water will keep receding until we are left with only a dry ocean bed. So it is with markets. They may recede for a time, but they eventually come back. Making sure you have a well-diversified portfolio of high quality investments can help you have confidence that your investments will still be there when the overall market recovers.
Another common cognitive distortion is called “filtering.” When we filter, we magnify the importance of negative information while ignoring or minimizing the positive information that is available.
If you want to see filtering in action, tune into most financial news shows. Their financial pundits are world champs at filtering. For example, between October 2007 and March 2009, the S&P 500 stock market index lost almost 50% of its value. Of course, there were plenty of economic problems to worry about in the financial crisis: unemployment was high, corporate profits were abysmal, and banks were in complete disarray. But it is also true that by the time the stock market bottomed in March 2009 stock prices were at their most attractive levels in decades. Despite the evidence, most pundits refused to believe it. They filtered out the positive evidence and continued to accentuate the negative. The result was they missed the first twelve months of what has turned out to be one of the biggest bull markets for stocks in American history.
Not surprisingly, one of the best ways to avoid filtering is to tune out the pundits. Pundits make their living by exaggerating the negative, so you can’t expect them to a balanced source of market information. As you consider the markets, remind yourself that there is always more than one side to every story. If you don’t see the positive, recognize the possibility that maybe you haven’t looked hard enough.
There are several other cognitive distortions that can get in the way of successfully living and investing. If you are interested in learning more about cognitive distortions and how to overcome them, you might find the book “Feeling Good” by psychiatrist David M. Burns, M.D. to be worthwhile. In addition, a good financial advisor can help you see through your cognitive distortions and stay on track with your investment discipline.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.