Our mind will play tricks on us if given a chance. We are bombarded by stimuli every day, and our brains often use shortcuts or heuristics to cope with the complexity of our environments. Shortcuts that prove harmless most times may, when applied to our finances, create unfavorable financial outcomes.
If you’ve heard the Yanny/Laurel recording, then you’ve experienced this phenomenon firsthand. People sitting around the same device listening to a recording of a voice saying a name often hear something completely different from one another.
How the Brain Hears Differently
University of Minnesota speech-language researcher Ben Munson explains how the brain can hear two different sounds from the same recording. Using spectrographic analysis, Munson explains that the brain is filling in the gaps to what it perceives.
The consonants that make up “Yanny” and “Laurel” are similar. Our brains are tricked by the sounds that come before and after these similar sounds. Our brain takes the shortcut and fills in the gap by interpolation. Simply put, if our brain has the beginning and the end, it often takes a shortcut to save time and energy.
In a process called categorical perception, the brain will simply categorize sounds and visuals, and once this stimulus is classified, the confusion begins. Researchers Robert L. Goldstone and Andrew T. Hendrickson note that people organize the world into categories that, in turn, alter the appearance of this perceived world. Our overwhelmed brains take shortcuts once we categorize stimuli similarly.
This occurs in visuals as well. (Remember the black and blue dress vs. the white and gold dress debate?)
In an attempt to understand our environment, our brain may give us conflicting signals depending on how it is categorized at the time of perception. All of this occurs behind the scenes, and we are unaware of any mistakes we may have made until after the fact.
How Does This Impact Your Money?
Our brains are constantly trying to make sense of the world, and money plays a very integral part in our general wellbeing. We as humans are pattern recognition machines, even when no patterns exist. Our need to make sense of the world and our need to control the environment can have harmful impacts when our perception unknowingly miscategorizes stimuli. This is a core reason behavioral investing can impact your financial goals, and why investors must work to recognize and correct these biases.
Many investors report good experiences with investing in real estate, primarily based on the fact that their family or friends did well and were profitable in their real estate transactions. In turn, they then categorize this type of investment as safer than other types of investments. The perception from another event experienced by a friend or family member is internalized and placed into a category of “good investments.”
On the flip side, those same people may have bought a luxury home in 2006 only to watch it lose half of its valuation in 2008 and 2009 during the big real estate bubble. They could easily categorize real estate as a “bad investment.” Neither of these conclusions is correct. Investments must always be judged on their current risk, and this current risk may be categorically different from our predetermined assessment of that risk.
How Does This Perception Evolve?
Using our real estate example, some of this stems from the dual nature of our experience with real estate. It is as much a home as it is an asset. Some of us had parents that bought their home in the 1970s or 1980s and sold it several years ago for a fairly large profit.
In reality, the value of the home went up and down at times, but your parents likely did not think of the house as an asset to be traded. They held on during the years when the value took a hit. Each year, as the family memories grew with the house, it truly became their home. Getting ready for retirement, with the kids moving off to college, parents decide to downsize and sell the home and pocket a nice profit.
In their minds and to those looking on, buying the home proved to be one of the best investments this family had made. The house kept up with inflation and provided shelter and memories with a tax-free profit at the end. It also brought with it an emotional reward alongside the financial benefits. It would make sense that your brain would process and categorize this as a great investment.
Does this make all investments in real estate low risk and great investments? No. However, how we have categorized the investment leads us to look upon real estate more favorably.
Fast forward a bit. It’s 2006, and a different family decides to buy a luxury home in a sought-after area where they have seen prices soar for the last several years. It’s a “no-brainer,” they think. Prices will naturally continue to rise as they have, and they, too, will be the beneficiaries of the real estate boom.
Then it happened. The Great Recession. The implosion of an 8 trillion dollar housing bubble rocked almost every nook and cranny of our economy. Consumer spending, the stock market, and employment rates all felt the impact. Our family who bought in the “nowhere but up” neighborhood now owes more on their mortgage than their home is worth.
During this time, it was hard not to personally be, or know someone, affected by the crisis. Many people were left with a bad taste in their mouths about real estate as an investment. Many had to let their homes fall under foreclosure or take a large loss.
What Does This Mean for Your Investing?
We must understand that our brains are machines of efficiency. To be more efficient, the brain may take a shortcut or two. Our memories will impact our thoughts and opinions on risk, even if the context of those memories are not applicable to the current situation.
We need to train our brains to be objective and understand the possible flaws that our categorization of experience may have on our investments. Is the decision that is currently comfortable for our minds the correct decision, or is it secretly biased? Learning how to avoid self-sabotaging your investments requires this level of self-awareness. Understanding the familyvest guide to wise investment also helps you recognize the most common traps that derail long-term plans.
One of the best ways to combat these types of issues is to obtain an objective third-party opinion from a financial advisor trained to be accurate and unbiased. Our investment management approach is built precisely around this principle.
