Building and maintaining a personal financial plan requires good decision making. That book, Noise: flaws in human judgmentfrom Daniel Kahneman (Nobel Prize-winning author) think fast or slow), Oliver Sibony, and Cass R. Sunstein try to explain why people make bad decisions and how to make better ones by blocking out the “noise” .
How can their insights be applied to financial decisions, especially regarding future security? Let’s find out.
What is noise? How does it affect decision-making?
The authors define noise as anything that causes variation in judgments that should otherwise be the same, such as environment, emotion, or time of day. Noise leads to inconsistent decisions by different people or the same person over time.
Noise is different from bias
Bias is something that can be identified and addressed. It’s a consistent, predictable error that tilts judgment in a certain direction. When judges consistently give harsher sentences to older offenders than younger ones, or when teachers give girls higher grades than boys, that’s bias, and it’s generally consistent.
Noise, on the other hand, is more random. It’s harder to detect and harder to fix.
The authors say, “Wherever there is judgment, there is noise, and there’s more of that noise than you think.”
In the New York Times, the authors explain the difference between bias and noise:
“To see the difference between bias and noise, consider your scale. If the average reading is too high (or too low), the scale is biased. If the scale displays different readings when you step on it several times in a row, the scale is noisy. (Cheaper scales are biased and can be noisy.) Bias is the average of the errors, while noise is the variation of the errors.“
Example of noise
The authors span a variety of fields, including medicine, criminal justice, child custody decisions, economic forecasting, employment, college admissions, forensics, business choices, and what happens to the choices that greenlight Hollywood blockbusters. We have recorded a huge number of examples of noise.
Here are some simple examples from this book.
Software developer: One study found that when software developers were asked to estimate the time to complete a task over two days, their predicted times varied by an average of 71%. Same question, but the results are very different and there is no clear reason why.
Judge: A study of 1.5 million cases found that judges were harsher when a local city football team lost the day before the verdict than they were the day after they won.
Doctor: Doctors are more likely to order cancer tests if they see patients in the early morning rather than in the afternoon.
Restaurant customers: When restaurants display the calorie count of menu items on the left side of the food rather than the right side, consumers are more likely to order lower-calorie menu items.
Forensic Scientist: Well, do you think fingerprint analysis is scientific? I mean, you’ve seen it on TV where they carefully measure the distance between grooves. no. Apparently, there is a lot of “noise” in this analysis. Not only do experts have differing opinions on fingerprint matching, but it is also common for a single examiner to reach inconsistent decisions at different times.
Underwriter: Insurance companies have the job of assessing risk. In one study, researchers found that the typical difference between ratings by two similarly trained insurers was 55%.
Radiologist: The radiologist was asked to take a series of X-rays and make a diagnosis. Sometimes we were shown the same X-ray images. In many cases, individual radiologists made different diagnoses the second time they saw the X-rays.
11 ways to reduce noise in financial decisions
noise is primarily a book about how institutions should strive to make decisions that are fairer, more accurate, and more reliable. However, there are ways to apply what they learn to their own lives.
Here are 11 recommendations to reduce the “noise” in your financial decisions.
1. Create and maintain an overall financial plan
You’re more likely to get where you want to go if you know where “there” is and have a plan to get there. By staying focused on your long-term goals, you can cut through the noise.
Boldin Retirement Planner is the most powerful and complete tool available online for long-term planning.
2. Check the data
“We are generally overconfident in our opinions, impressions, and judgment,” Kahneman said. Increases data reliability.
Ideally, all decisions could be replaced by fully tuned algorithms built to your specifications based on your resources, values, and goals. You can use your data to generate predictions to help you make the perfect decision.
While this type of algorithm isn’t always possible, tools like Boldin Retirement Planner give you a great deal of power and control. Planner allows you to model different scenarios and evaluate different potential outcomes.
Need to make a financial decision? Run different scenarios to see what the data says.
3. Formalize the rules
Not everything can be analyzed with data. When you can’t use algorithms to make decisions, it’s helpful to have a set of rules to help you know what to do.
For example, consider asset allocation. The way you invest your money needs to be based on some kind of logic, and the actions you take when your asset allocation is out of balance need to be predetermined. Therefore, if the stock market falls rapidly and your funds lose value, you should already know what to do in that case.
This may be the role of an investment policy statement (IPS). IPS aims to define:
- investment goal
- Strategies to achieve those goals
- A framework for making intelligent changes to your plans
- Options for what to do if things don’t go as expected
4. Break down decisions into easier subjudgments
A single decision involves many variables.
For example, let’s say you’re planning to buy a vacation home. Variables that will influence your decision include all factors related to the home itself (location, size, type of home, proximity to family, personality, maintenance costs, etc.) and factors related to finances (down payment, etc.) , cash flows, interest rates, etc.). , PMI, period, etc.).
The authors suggest that it may be useful to score individual elements of a decision rather than the entire decision.
Therefore, you can create a list of all the variables and score each one in relation to your holiday home. I would give it a 4/10 because it has a negative impact on my cash flow, and a 10/10 because my enjoyment with my family has been positively impacted. Right away.
5. Determine if there is “system noise” (hidden bias).
Money is not a completely mathematical task. Your approach to money, both moment-to-moment and overall, can be highly emotional.
Understand your rich personality: It may be important to understand your relationship with money. What is your rich personality type and what drives you? These underlying values can be “system noise” that influences decision-making.
For example, you may have grown up without much money. That experience may make you particularly frugal in some cases and spendthrift in others. Understanding this about yourself will help you make better decisions.
Look for noise. If everything is going well in your life, you should approach investing differently than if you are feeling anxious about something, even if that anxiety has nothing to do with having to make a financial decision. There is a possibility of working on it.
When making decisions, it may be helpful to take a moment to assess what “noise” is affecting you. It may not always be possible to identify it, but it doesn’t hurt to look.
6. Get multiple quotes if applicable
Financial decisions often require outside expertise. For example, you may need home appraisals, insurance adjustments, mortgages, investment guidance, etc. Please keep in mind that these estimates and estimates can vary widely and are sometimes due to “noise”.
It’s a great idea to take multiple evaluations and choose the one that makes the most sense or will benefit you the most.
7. Minimize regrets
Kahneman says, “Regret is perhaps the biggest enemy of good personal finance decisions.”
Research shows that the more likely you are to regret, the more likely you are to make the wrong decision.
regret theory claim that people expect to have regrets and may make bad decisions based on the bad things that might happen, not necessarily on the current situation. probably things that happen.
Therefore, when making decisions, we need to understand that the possibility of regret may lead us to make suboptimal choices.
8. Make sure you are asking the right questions
If you’re not asking the right questions, you’re very unlikely to get the right answers.
A common problem in retirement planning is that many people primarily want to know: 1) whether you can retire early, and 2) how much money you need to retire.
These are valid questions, but until you decide how long you expect to live and how much money you need or want to spend in that time, you can’t get valid answers to the questions you really need answered.
Boldin Retirement Planner lets you vary your spending over your lifetime and run scenarios at different life ages to get reliable answers about your future security. Want to know when you can retire? First, let’s make a concrete budget for the future!
9. Get input from trusted advisors, especially those who think differently than you.
Getting opinions from people you trust can broaden your perspective and prevent you from making bad decisions. Simply hearing different opinions can quiet the noise that can lead you in the wrong direction.
Kahneman says the ideal advisor is “someone who likes you and doesn’t care about your feelings.”
However, it is also important to understand that:
- What the advisor can gain from some conclusions
- What kind of noise might they encounter when expressing their opinion?
- The relevance of the data used to make the decision — was it anecdotal or data-based?
10. Automation
Automate your savings, investments, and bill payments. It removes the human element of noise from the equation and enhances consistency.
11. Don’t overestimate short-term profits
Humans have an inherent bias towards short-term gains. However, financial decisions are important not only for the present, but also for the entire future.
It’s important to always think about how the decision will affect your life now. For example, will you have less or more money to spend this month? However, it’s equally important to consider how your financial decisions will affect your future. Eating out takes $100 off your savings and investments, but that alone doesn’t make your financial outlook better or worse. But doing this every week can take you a year away from the life you want in retirement.
Today, we’re sharing 7 tips to help you connect with your future self to make better money decisions.
