Recently I came across the interesting writing of David McRaney from his latest book, “You Are Now Less Dumb”, where he explores the human “self-delusions and irrational thinking and how we succumb to them both every day.” Many of the ideas he discusses in the book intrigued me to draw comparisons to our financial behavior. Therefore, I’m starting a series to share some of these idiosyncrasies and the practical steps we can take to make them work in our favor.
Narrative bias refers to our tendency to make sense of the world through stories. To process the great amount of information coming our way, our brain creates a narrative to link the different inputs together, and drops the other facts that do not fit in the story. The process cooks up a causal relationship of all the facts that may not exist, but it helps us retain and make use of information more efficiently. Furthermore, the narratives only work in your existing frame of thoughts; therefore they usually only reinforce your original beliefs and understanding of the world.
One type of narrative bias I encounter in my industry is the tendency to use anecdotes to justify our investment decisions. While good investment decisions should be built on quantitative methods and statistical evidence, they are not easily explainable and understood. Therefore we pile one positive fact on top of the other to make a convincing story, although not all of them actually are the cause of good performance.
For example, you may decide to buy Apple stocks because it seems like everyone you know uses their products, so you reason that the company will stay strong and grow in value. However, you never looked at their sales data, compared it to competitors, have insider information on their upcoming product pipe line, study their financial disclosures, etc. Even if you did have access to all this, you still need to assume that these favorable economic and financial data actually will translate into stock performance. Nobody has the time for this, so it’s easier to have a simple explanation for your action.
So if narrative bias is something ingrained in our brain, how can we make it work in our favor when dealing with our finances? Here are three steps I think that will help:
#1: Make a Story
How do you envision your life playing out, and what are you doing financially to get there? As humans, we do not like black boxes, and not being able to see how things work inside the black box induces anxiety. If you feel like your financial efforts are entering a black box and producing results outside of your control, then financial planning can really help you open up the black box and make sure things work the way you can understand.
Financial planning itself is a narrative. It involves understanding where you are, where you want to be, and what you do to get there. It makes perfect use of our bias toward a narrative but built on actual mathematical foundations. Once you can articulate an overarching story of your life and the financial steps that move you linearly forward, you feel a greater sense of control and can focus on other parts of life that are more fun. And as financial planners, we make sure what you do actually works, instead of following a fantasy that you dream up.
#2: Make Connections
Another way to make use of our narrative bias is to make a direct connection between two financial behaviors that may not be obviously related. Since our brain likes to see cause and effect, being able to see the immediate result from our action reinforces our behavior.
For instance, you are debating if you should go out to dinner tonight again. Let’s say it will cost you $60 overall, while cooking at home will cost you $10. You know mentally that by staying home you will save $50, but it’s not reflecting anywhere immediately to make that decision easier for you. To make that connection quick and effective, you can go online, immediately move $50 from your checking account to your savings account, or make an extra payment on your credit card or student loan. The observable change in your account balance will make your saving behavior stronger.
Another good example is making “policies” that connect your saving to more distant goals. If you usually get a bonus or tax refund in the beginning of the year, you can set a policy that says,
“Contribute all my tax refund / bonus to my son’s 529 account”, instead of
“Save my tax refund / bonus”.
A clear designation of where your funds flow makes it more likely for you to stick to the policy. If you pool all the savings together without purpose, your savings may quickly turn into a black box your brain won’t process easily.
#3: Make Meaning
Lastly, our bias toward narrative also means our brain works more effectively when we attach meaning to our behavior- the “why” in the story. In addition to seeing your goals as the reason for doing certain things at the macro level, you may also judge your financial behavior based on your personal values at the micro level. As I’ve shared before on this blog, a “Value-Driven” budget system utilizes our mental accounting tendency while making our purchases meaningful at the moment to help us reduce the stress associated with detail budgeting.
I also find making meaning a useful tactic when you make investment decisions. (Although, for an investor, maximizing return should be the number one priority.) Many find investment decisions difficult to process not just because of the math, but because seeking profit alone doesn’t help us internalize the reward and make us a happier person. The same phenomenon explains why volunteers are usually more satisfied with the experience than unpaid interns, even if they do the exact same job. This is partially why I began writing the “Rethink Investing” series, to help you find meaning in your investment decisions so you can be a happier investor.
So what is your narrative, and how do your financial decisions fit in your narrative?