Terrance Odean is the Rudd Family Foundation professor of finance at the Haas School of Business at the University of California, Berkeley. Odean had initially been interested in psychology, but was drawn to pursuing a Ph.D. in finance after learning that the dominant theories in finance are based on the assumption that people are hyperrational when it comes to money. That fascinated him because it’s simply not true: People have systematic biases, which makes it possible to predict the type of mistakes they'll make and when they’ll make them.

Odean’s research into cognitive bias can help others recognize when they’re going to make financial mistakes and if those mistakes are inevitable or if they can be overcome. Here are his suggestions on how best to optimize your financial mindset:

Automate away bias

People’s tendencies are to hold on to losing investments and sell winners (known as the “disposition effect” in behavioral finance). From a tax point of view, that's suboptimal, and in many respects it doesn't work out well for people. Professionals, however, will introduce automation to remove choice from the equation. That automation might have a rule to sell a position that’s dropped 10%, which eliminates any deliberation about whether to hold or sell. Automation takes the choice out of what to do with money, and that means not giving yourself the option of making a financial mistake.

Recognize different types of bias

Odean recounts the story of a brother and sister in his neighborhood who inherited their father’s house and wanted to sell it. A real estate agent told them the home was worth $400,000, so when Odean offered to buy the house for $300,000, the brother and sister told him they couldn’t take that much of a loss.

Survivorship bias - This is the mistake of ignoring failures, another example that hits homeowners. In rapidly escalating housing markets, the tendency is to regret not buying sooner. While San Francisco homeowners may say, “I wish I’d bought a home 20 or 30 years ago,” that’s not the rule across the entire U.S.

Homebuyers tend to think that the recent past predicts the future. But real estate, like other investments, goes both ways. It’s important for homebuyers to realize they’re taking a financial risk, even if they are currently in a strong housing market. It’s one thing to be optimistic, but another thing to fall into “that could never happen to me” thinking. The bottom line is that a home is as risky as an equity index.

Look at the long term

Even though homes are riskier investments than most realize, they’re also long-term investments. Be aware of the risk going in, but don’t get obsessed with looking at the variations in value. Odean tells his students to buy a well-diversified portfolio of low-cost mutual funds or index funds and don't follow it every day. In fact, he only looks at his portfolio once every year.

Be aware of the risk, but don’t obsess about small movements in long-term investments.

Alleviate the risk

Odean recommends alleviating financial risk whenever possible, and that involves diversification. Instead of investing all of your money in the down payment for a home (which, as previously discussed, is a risky investment), utilizing a co-investment solution allows homeowners to invest some of their money in the home and divert the rest to other investments such as stocks or bonds.
When it comes to buying a home, Odean advises homebuyers to see what their price range is, not based on what they want but what they can afford. Then, be sure to only look at homes within your price range. Next, get at least four quotes on a mortgage — make sure that you're comparing mortgages with all of the same fees and features — and find the best possible interest rate.

Dive deeper into Terrance Odean’s research on cognitive bias and learn more about mitigating the risk of homebuying by viewing the video here:

Watch the interview:

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