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Making investments comes with a number of inherent risks, including duration or interest-rate risk for bonds, volatility risk with stocks, liquidity risk for less liquid investments such as real estate, and many other risks that can usually be modelled or measured. However, there is another risk factor that is harder to quantify but is equally important to consider: human behavior and biases.

The field of behavioral economics gets at this issue by studying how individuals make financial decisions, particularly when faced with complex choices or uncertainty. In general, people use all kinds of mental shortcuts to make decisions, such as giving recent information more weight than prior information (recency bias), overestimating the validity of small sample sizes (representativeness), and seeking confirming evidence to support established ideas (confirmation bias), all of which have the potential to lead to poor outcomes. When struggling with complex decisions, like whether to invest in a stock, people will often simplify things and allow their decisions to be affected by one or more of these shortcuts.

While this approach can help someone make decisions quickly, it can also get in the way of good decision making. I always try to ask myself a few things before making any significant decision:

1. Have I based my decision on small sample sizes or irrelevant data?

2. Did I reach out to the people who know the issue or question best? Did I ask someone with a different viewpoint, and in a way that they are not afraid to speak with candor?

3. Have I ignored information that counters my view and only looked for evidence that confirms my opinion? Have I spurned other ideas as bad simply because the information is new, different or not something I want to believe?

4. How rigorously have I studied my past decisions, especially ones that didn’t go well, to look for common themes? Do I understand the conditions under which I tend to rush to judgement but should take more time, or areas where I need to talk to different experts?

It’s OK to think both “fast” and “slow”

There are lots of other things individuals can do to combat common biases and become more rational, competent decision-makers, but one of the most important things to do is gauge how critical the decision is before making a choice. If it has tremendous downside or can’t be undone without great cost, such as borrowing against your 401(k) or house to launch a startup, then it’s especially important to put time into the decision-making process to minimize the effect of biases. However, if it’s a less impactful decision that involves a smaller amount of money, such as making a $100 purchase or investment, it can be OK to decide more quickly and possibly rely on a mental shortcut.

Dr. Daniel Kahneman¹, who was a pioneer in the field of behavioral economics, wrote a book called “Thinking, Fast and Slow” that explores this idea in more depth. For investors, the key takeaway is knowing when a quick decision is OK versus when it’s better to slow down and think more carefully. Being aware of our own biases and the mental shortcuts we often take — and understanding how to counteract them when needed — is a great first step in making sound financial choices.