By: Joe Delaney
Imagine you awake in a strange place and can’t remember how you got there. Worse, as an alarm is sounding in your ears and smoke surrounds you, you realize you can’t even remember who you are.
You look around, frantic. You see things that strike you as familiar, but all you can think about is the alarm, so loud, so insistent.
Your instincts tell you where there’s smoke, there’s fire. You run from the room, down the stairs, toward the front door. As you reach out your hand to open it you notice a large, red box hanging from a hook exactly at eye level.
The face of the box is a window that reads: “In case of emergency, break glass.”
You see a little hammer on the side. Without a clue why you’re doing it, you pick up the hammer and obey the command. Behind the shattered pane you discover a folded note.
You open the note and instantly recognize your own handwriting. Alarm still blaring, you read:
“There is a smoke machine in the basement. Sometimes it goes off by itself and sets off the smoke detectors. DON’T LEAVE THE HOUSE. If you don’t shut the machine off, it could start a real fire. Thanks.”
Is this a joke? That’s definitely your handwriting, but why would you have a smoke machine? Every instinct says to run.
What do you do?
“WHERE THERE’S SMOKE, THERE’S FIRE” – RECOGNIZING RECENCY BIAS
The scenario above is an extreme example of a common habit among human beings: we have a tendency to believe that what is happening now or recently is a better predictor of the future than the distant past. We have a “recency bias.”
“Where there’s smoke, there’s fire,” is considered a universal truth, except in the one scenario where it isn’t so. If you woke up to discover an alarm going off and smoke in the room, of course you would run. That recent input is usually a good predictor of fire and danger.
The only reason you wouldn’t flee is if you had previously planned not to. You understood something prior to your current state of fear and confusion that “common sense” isn’t telling you now.
“IN CASE OF EMERGENCY, BREAK GLASS” – PRE-CRISIS PLANNING
In investing, it is vitally important to write notes to yourself that might one day seem as crazy as the one in the amnesia scenario. Just as it will make no sense to you that there is a smoke machine in your house, it will make no sense to buy when the market dips. It will feel just as wrong as staying in the house when it is filled with smoke.
The opposite version of this scenario might involve a note telling you not to enter the house even when it looks warm and inviting. When the markets are on the rise it feels right to keep buying, expecting the rise to continue. Why would you stop?
The only thing that can stop you is you, by way of this note undeniably in your own handwriting you’ve forgotten all about.
“INSTINCTS FAIL, COOLER HEADS PREVAIL” – OVERCOMING RECENCY BIAS
At this moment, the air is clear and concepts like “buy low, sell high” make sense to you. But just like waking up in a smoke-filled house and being told not to leave is disorienting, so will following the plan when a financial crisis comes along. It may feel like you have amnesia because your own plan might simply make no sense to you in the heat of the moment.
Preventing financial amnesia requires two important steps:
- Make a plan. The best defense against your future self is to work with a financial advisor to build the big red box, write a note in your own handwriting and put it inside. This is your investment plan that will tell you exactly what to do when the markets shift.
- Monitor the plan. After that, check in with your advisor on a regular basis to discuss your portfolio’s performance against your goals. This will help you remember who and where you are along a long-term investment course when the alarm goes off.
At Lifeguard Wealth, after helping clients set goals we are more than happy to keep them informed about how we are doing relative to those goals. Our clients should never wake up in the morning fearful and disoriented.
We’re there to remind them that sometimes smoke is just … smoke.
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The opinions expressed by myself and other featured authors are their own and may not accurately reflect those of Lifeguard Wealth. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
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