Written by: Daniel Crosby, Ph.D.
Most of us approach financial decisions with the same instinct we bring to most areas of life. We figure out what we want to happen and then we look for reasons it will. The investor evaluating a stock looks for reasons the stock will go up. The entrepreneur considering a new venture looks for reasons it will succeed. The household considering a major purchase looks for reasons it makes sense. The instinct is so natural that we rarely notice it operating.
Behavioral economists call this confirmation bias, the well-documented human tendency to seek out information that supports what we already believe and to dismiss information that contradicts it. The English philosopher Francis Bacon described it nearly 400 years ago in language that still applies precisely to modern financial decisions. "The human understanding when it once adopted an opinion draws all things else to support and agree with it. And though there be a great number and weight of instances to be found on the other side, yet these it either neglects and despises or else by some distinction sets aside and rejects."
The investor Warren Buffett has captured the practical implication in characteristically simple terms. "An investor needs to do very few things right as long as he avoids big mistakes."
The trouble is that avoiding big mistakes requires a habit of mind that runs against our natural wiring. Asking "why might this be a good idea" comes easily. Asking "why might I be wrong about this" requires deliberate effort, and most of us avoid the discomfort of the second question even when the first one has already been thoroughly answered.
Berkshire Hathaway's Charlie Munger had long advocated a simple discipline he summarizes as "invert, always invert." The idea is to take any decision you are considering and deliberately turn it upside down. Instead of asking how to succeed, ask how to fail. Instead of asking what to do, ask what to avoid. Instead of asking what could go right, ask what could go wrong. The inverted question often produces clearer answers than the original one.
Investment thinker Michael Mauboussin has formalized this kind of thinking into a five-part checklist that adapts well to most consequential financial decisions.
- Consider alternatives. Decisions are only good or bad relative to the other options available. What is the next best use of this capital, this time, this attention?
- Seek dissent. Actively invite people to argue against your conclusion. Then resist the urge to argue back. Listen instead.
- Keep track of previous decisions. Write down why you are making the choice now, in the moment. Review the notes later. Patterns will emerge that pure memory cannot reveal.
- Avoid making decisions in emotional extremes. Stress, excitement, fear, and pride all distort the perception of risk. The decision that feels obvious in those states is rarely the decision your calmer self would endorse.
- Understand incentives. Know what you stand to gain and lose, and recognize how those stakes are coloring your analysis.
A useful practice for any household, business owner, or family making consequential financial choices is to conduct what is sometimes called a pre-mortem. Most of us are familiar with the post-mortem, the analysis conducted after something has gone wrong. The pre-mortem reverses the timing. Before committing to a decision, imagine yourself two years in the future, looking back at how the decision turned out badly. Then write down the most plausible reasons it failed. The exercise often reveals risks that no amount of optimistic planning would have surfaced.
The trader and psychologist Brett Steenbarger has captured the principle precisely. "I have found that a large percentage of my winning trades begin with a rehearsal of negative, what-if scenarios. Conversely, I have found that my worst trades begin with an estimate of my potential profits."
Most real wealth, over a lifetime, is built by avoiding catastrophic mistakes rather than by hitting dramatic home runs. The discipline of asking what could go wrong is one of the more reliable ways to identify those mistakes before they happen.
This week's challenge: Pick one significant financial decision currently on your plate, then deliberately conduct a pre-mortem; imagine yourself two years from now explaining why the decision turned out badly, write down the most plausible reasons, and let the answers shape what you do next.
Related: Show Me Where You Spend Your Money, and I’ll Show You What You Value
