Decision making is a skill. A lot of us go through our lives making decisions every day – big and small. Some of us are considered ‘good’ at it, and some others lament about how ‘bad’ their decisions are. I am not today going to wax philosophical about the relativity of good and bad decisions. But I am going to talk about a framework and some core principles to keep in mind as you think about decision making – as it pertains to your personal finances. A lot of these principles and frameworks will apply to general decision making as well. So let’s begin.
Principle 1: Don’t judge your decisions based on outcomes.
I want to start with what I consider one of the most important principles in decision making and will spend the most space talking about this. You get this right – you will get a lot of things right. This is probably one of the most counter-intuitive principles out there but I have talked about this in one of my earlier articles. Annie Duke, world class poker player and author of the book ‘Thinking in bets’ explains this beautifully. She explains the concept of the resulting fallacy – which is that people judge the quality of their decisions based on the outcomes. You may be like – how else do I know if I made a good or bad decision? If the outcome was good, then it was a good decision and if the outcome was bad, it was a bad decision. Right? No – that is absolutely not the way to think about it.
Let me explain – a decision is made based on a bunch of inputs and assumptions that you are aware of, at that time. Sometimes people may make decisions without considering any inputs either and go by their ‘gut’. The outcome however can be influenced by a number of factors, known and unknown. Take the simple example – you approach a traffic light and you see the light is red. You decide to jump the light anyway and no, you don’t get caught by the cops or meet with an accident. Do you high-five yourself and say – that was an excellent decision because I saved a bunch of time and the outcome was great too? No – you just got lucky. That was a poor decision. Bear with me – I am not trying to be patronizing here. I am simply trying to explain the concept. So let’s take the idea of investing in stocks. You hear about a hot stock – you cannot go wrong. So you invest in it. You make a killing in 3 months. Was that a good decision? Unless your thought process for investing in stocks involved doing some clear research and analysis and based on that, you decided to buy it, then I would argue your decision making process was not sound. You just got lucky.
Similarly, a bad outcome does not mean your decision making process was bad. In the book, Annie Duke explains how a few board members were lamenting about the fact that they had made a bad decision by hiring a CEO who had really struggled. But after she questioned them on their thought process, she found it to be really sound. They had asked all the right questions, focused on the right skills and got some great references before hiring the CEO. So what happened? One of the things that went south was the external macro environment changed dramatically causing sales to dramatically drop. The changes in the macro environment was not something that was predicted. Like I said, there are a lot of inputs and assumptions that go into a decision. But the outcome can be influenced by so many things. Here, Annie surmised, the decision making process was still sound but the outcome did not end up being great not because the CEO was necessarily a bad hire. Now, there was a lot more to this example but I am just giving the high level view to explain the idea.
So ultimately, focus on your decision making process. When you are making a financial decision – whether it’s to buy an asset or repay debt or invest in something, ask yourself if you feel you have a sound decision making process. Why this focus on process? Because a process is what is repeatable and you can continuously improve on the process. A good process has a high correlation to a good outcome most of the time. If it’s pure ‘gut’ then you cannot explain whether or not your decision making process was sound. By the way, ‘gut’ is not something to be dismissed either – most often it’s a function of a collection of experiences which also matter and can also be considered as an input in your process.
So then if outcomes are not guaranteed how do I make decisions to have better outcomes? So first off, there is no guarantee on an outcome – lets be clear about that. Once you have accepted that, then read the next principle.
Principle 2: Thinking in bets – probabilistic thinking
I talked about this in my article “Does cryptocurrency have a place in my portfolio” so I won’t repeat myself here. But in short, we all need to develop the capability of thinking in a manner where we try and understand the probability of the outcome of a decision. Even if you don’t build out a crazy, geeky mathematical model (which most of us average investors will not do), just apply this principle. Based on what you know and historic data, do you believe the probability of the outcome will be high or low? So for eg. It’s a well known fact that active investing in stocks is a bit of a crap shoot and can go either way. Conversely, it’s well known that in the long run, passively investing in the stock market through index funds has a much higher probability of giving you higher returns.
Principle 3: Think long term and have a ton of patience
There is no such thing as a ‘get-rich-quick’ scheme. Wealth is built slowly and steadily. So as you make financial decisions, if you think long term you will definitely have a much higher chance of success. Why is that? For two reasons – one, when you invest for the long run – the majority of asset classes will have historical data that show growth over a long period of time. If you think in terms of 20-30 years, you have this advantage. (Now I know there will be some pundits who will show some asset class that has actually declined in that time period but this is the general truth for the more common asset classes like stocks, bonds and real estate).The other obvious reason I have talked about is the power of compounding. When you think long term, you have time on your side to allow all this money to compound.
This understanding of time needs to be coupled with patience. If you start getting fidgety and start trying to time the market, buying and selling constantly, you will not receive the benefits of this. Similarly, saving small amounts each week/month/year may not feel like you are making progress but you will make progress over the long run. Dorie Clark, a consultant, keynote speaker and a professor, in her new book “The Long Game” talks about how companies and individuals should think long term and make small changes today that will have a disproportionate impact in the long run.
Principle 4: Don’t try to time the market
This is an oldie but a goodie. All of us, myself included, fall prey to this. When we are trying to make a financial decision, we often are tempted to time the market. Maybe the market will go down soon or it will go up soon and then decisions to buy and sell are made based on that. Your decision to buy an asset for eg. has to be made based on the attractiveness of the asset and its returns, independent of whether you think the asset will appreciate or depreciate over time. Let me give you some examples. The common one is trying to buy low, sell high in the stock market. If you follow the previous principles, then you should not care about near term gyrations of the stock market. Just buy and plan to keep it for another 20 years and the probability of it appreciating is very high. Similarly, in the real estate market, people are constantly trying to understand if the market is heated or at a low, are interest rates going to rise or go down and accordingly try to buy the asset. You should evaluate the investment in the asset independent of all this. If it is a piece of real estate for investment, look at the CAP rate and if it’s attractive buy it. If it’s a personal residence, ask yourself whether it meets all the criteria you have laid out, which will be a mix of both financial and nonfinancial criteria. If it meets the criteria, then just buy it or sell it.
Trying to time the market makes people feel smart – or stupid, depending on the outcome. I go back to the first principle I laid out. Focus on the decision making process rather than the outcome.
While the above principles are not necessarily exhaustive, if you combine the above 4 and constantly remind yourself of them as you make financial decisions, you have a very high probability of success. I know that’s a very strong statement but I can tell you this from personal experience and from other more experienced people’s experiences.
Thank you for reading and I wish you success in your financial journey.
Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.
