5 Steps to Making Better Financial Decisions
The key is thinking slowly
As a financial planner, I once attended a training course on how to land a new client. The course was all about whipping up excitement with the goal of getting the prospective client to sign. I was told to ask them what they would do with their lives if money was no object. Get them to imagine and feel the immense pleasure from their new life, irrespective of whether it's volunteer work, spending time with the grandkids or even golfing every day. Then tell them I can get them to this new life — and then make sure they sign on before they walk out and have time to think about it.
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There was a lot of psychology in that training course intended to exploit emotion and the impulse to think quickly. Nothing was presented logically as to why the client would be better off with any of us as their financial planner. By employing these tactics, we would be free to sell clients all sorts of products and plans. I felt like I needed a shower after taking this dirty course.
A much better way
But perhaps there is lemonade to be made from this lemon of a course, especially when combined with Nobel laureate Daniel Kahneman's book Thinking, Fast and Slow. Kahneman explains that we have two systems of thinking. "System 1" is fast, instinctive and emotional, while "System 2" is slower, deliberate and logical. The course I attended was all about getting clients to think using System 1. So given that, then the secret to making better financial decisions is to wait until your System 2 kicks in — or to force it to.
Here are a few steps to make sure you engage System 2 – slow thinking — when making any important financial decision, such as buying a stock, fund or other financial product.
1. Never make a quick decision. Though you may convince yourself you are thinking logically, you may not be. No matter what, wait at least a day or longer. If someone tells you the offer is only good for today, run.
2. Create a list of outcomes. Make sure to write down at least a couple of ways your decision can go wrong and how much money you could lose. If you think it's a sure thing and that nothing can go wrong, then that's a strong sign System 2 hasn't engaged.
3. Change roles. In addition to asking yourself how this can be good for you, also consider how the person or company selling it to you benefits. Their motivation may not be in your best interest.
4. Get data. My training course, for instance, was counting on the client not asking what my track record was or exactly how I was going to get the client to reach financial independence, much less why I was different from other planners. So ask questions — and demand answers.
5. Discuss the decision. Talk it over first with someone you trust and respect, but who doesn't always agree with you. This has two benefits. First, it forces you to try to actually understand something first so that you can explain it to someone else. Second, you are getting feedback from someone who doesn't have an emotional vested interest from this decision.
The truth is that these five steps to thinking more slowly apply to all important decisions, not just financial ones. Following them many not protect you from making mistakes in the future, but you'll make fewer and less costly ones.
So my advice is to think slowly and prosper.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.