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May 20, 2021
Building and maintaining a personal financial plan requires good decision-making. A new book, Noise: A Flaw in Human Judgment, from Daniel Kahneman (Nobel Prize-winning author of Thinking, Fast and Slow), Oliver Sibony, and Cass R. Sunstein attempts to explain why people make bad decisions and how to make better ones by cutting through the “noise.”
How can their insight be applied to your financial decisions, especially where it comes to the security of your future? Let’s find out.
The authors define noise as a difference — in the environment, emotions, time of day, or anything — that results in variability in judgments that should otherwise be identical.
Bias is something that can be identified and dealt with. It is consistent — a predictable error that inclines your judgment in a particular direction. If a judge always sentences older criminals more harshly than younger ones, or if a teacher grades girls higher than boys, that is bias and it is generally consistent.
Noise, on the other hand, is more random. It is more difficult to detect and more difficult to correct.
The authors state that “Wherever there is judgment, there is noise — and more of it than you think.”
In the New York Times, the authors describe the differences between bias and noise like this:
“To see the difference between bias and noise, consider your bathroom scale. If on average the readings it gives are too high (or too low), the scale is biased. If it shows different readings when you step on it several times in quick succession, the scale is noisy. (Cheap scales are likely to be both biased and noisy.) While bias is the average of errors, noise is their variability.“
The authors chronicle a huge number of examples of noise across medicine, criminal justice, child custody decisions, economic forecasts, hiring, college admissions, forensics, business choices, what goes into choosing to greenlight a Hollywood blockbuster, and more.
Here are a few quick examples from the book:
Software developers: One study revealed that when software developers were asked on 2 separate days to estimate completion time on a task, the hours they projected differed by 71% — on average. Same question, wildly different results with no clear reason why.
Judges: A study of 1.5 million cases found that when the local city’s football team lost on the day before sentencing, judges were tougher than on days following a win.
Doctors: Doctors are more likely to order cancer screenings if they see the patient in the early morning instead of the afternoon.
Restaurant goers: If a restaurant puts calorie counts on menu items to the left of a food item instead of the right, consumers are more likely to order the low-calorie choice.
Forensic scientists: Okay, you would think that fingerprint analysis would be scientific? I mean, we have all seen on TV how they carefully measure the distances between grooves. Nope. Apparently, there is a lot of “noise” in this analysis. Not only will different experts disagree on fingerprint matches, it is not uncommon for a single examiner to arrive at inconsistent decisions at different times.
Underwriters: Underwriters have the job of assessing risk. In a study, researchers found that the typical difference in an assessment by two similarly trained underwriters was 55%.
Radiologists: Radiologists were given a series of X-rays and asked to diagnose them. Sometimes they were shown the same X-ray. In a high number of cases, individual radiologists gave different diagnoses when they saw the X-ray for a second time.
Noise is a book primarily about how institutions should strive to make decisions that are more fair, accurate, and credible.
Here are 11 recommendations for reducing “noise” in your own financial decision-making.
You are more likely to get where you want to go if you know where “there” is and have a plan for getting there. Stay focused on your long-term goals and you can reduce noise.
The NewRetirement Planner is the most powerful and complete tool available online for long-term planning.
Kahneman has said, “We’re generally overconfident in our opinions and our impressions and judgments.” Data is more reliable.
Ideally, you could replace all decision-making with a perfectly tuned algorithm — built to your specifications based on your resources, values, and goals. You could use data to produce a prediction and help make a perfect decision.
While this kind of algorithm is not always possible, tools like the NewRetirement Planner do give you a tremendous amount of power and control. The Planner enables you to model different scenarios and assess different potential outcomes.
Need to make a financial decision? Run different scenarios and see what the data has to say!
Not everything can get analyzed with data. When you can not use an algorithm to make a decision, it is useful to have a set of rules to help you know what to do.
For example, let’s take your asset allocation. How your money is invested ought to be based on some sort of logic and the actions you take when your asset allocation falls out of balance should be predetermined. So, if the stock market falls quickly and your funds lose value, you should already know what you are going to do if that happens.
This can be the role of an Investment Policy Statement (IPS). An IPS is meant to define:
There are a lot of variables that go into any one decision.
For example, let’s say that you are planning on buying a vacation home. Variables that impact your decision include everything related to the home itself (location, size, type of home, proximity to family, character, upkeep, and more) as well as the factors related to your finances (down payment, cash flow, interest rate, PMI, term and more).
The authors suggest that it can be useful to score each individual component of the decision instead of the decision as a whole.
So, as related to the vacation home, you could make a list of all the variables and score each — cash flow is negatively impacted so it gets a 4/10, having fun with family is positive so it gets a 10/10, and so on.
Money is not entirely a mathematical undertaking. Your approach to money can be hugely emotional — both in the moment and overall.
Understand your money personality: It may be important for you to understand your own relationship with money. What is your money personality type? And, what is motivating you? These underlying values could be “system noise” that is coloring your decision-making.
For example, you may have grown up without a lot of money and that experience might make you particularly thrifty in some instances and spend-y in others. Understanding this about yourself can help you make better decisions.
Look for the noise: If everything in your life is going great, you are likely to approach your investments differently than if you are feeling anxious about something — even if the anxiety is totally unrelated to the financial decision you need to make.
When making a decision, it may be useful to take a second and assess what “noise” may be influencing you. You might not always identify it, but it won’t hurt to look.
A lot of times when making a financial decision, you require outside expertise. For example, you need home appraisals, insurance adjustments, mortgage loans, investment guidance, and more. Just remember that these quotes and estimates can vary widely — sometimes due to “noise.”
It can be a great idea to get multiple assessments and choose the one that makes the most sense to you — or that benefits you the most.
Kahneman says that “Regret is probably the greatest enemy of good decision making in personal finance.”
The research suggests that the more potential there is for regret, the greater chance there is that you will make a bad decision.
Regret theory posits that people will anticipate regret and make potentially bad decisions based on bad things that might happen, not necessarily on what is likely to happen.
So, when making a decision, you need to understand that the potential for regret may cause you to make a sub-optimal choice.
If you aren’t asking the right question, you have little hope of getting the right answer.
A common problem in retirement planning is that many people primarily want to know: 1) If they can retire early and 2) How much they need to retire.
These are valid questions, but without determining how long you are going to live and how much you need or want to spend during that time, you can not get to a valid response to the questions for which you really want answers.
The NewRetirement Planner enables you to vary expenses over your lifetime and run scenarios with different longevity ages to help you get reliable answers about your future security. Want to know when you can retire? First, create a detailed future budget!
Getting input from people you trust can help expand your perspective and limit bad decisions. Just hearing differing opinions can quiet noise that might lead you astray.
Kahneman says that the ideal advisor is “A person who likes you and doesn’t care about your feelings.”
However, it is also important to understand:
Automating savings, investing, monthly, and bill paying are all great ideas. It takes the human element of noise out of the equation and enforces consistency.
Human beings have an inherent bias toward short-term benefits. However, your financial decisions are important for today, but also your entire future.
It is important to always consider what impact a decision will have on your life right now. Will you have less or more money this month to spend, for example. However, it is equally important to think about how your financial decisions will impact your future. A dinner out means $100 less to save and invest which alone won’t make or break your financial outlook. However, if you are doing it weekly, you could be taking a year away from the life you want in retirement.
Here are 7 tips for connecting with your future self in order to make better money decisions today.
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