For Tough Portfolio Decisions, Think of Helping a Friend

When it comes to making tough decisions, the best question may not be, “what should I do?" You might be better off asking what you would tell a friend to do if he or she were in the situation.

Psychologists call this strategy self-distancing. It's a behaviour that can help remove some of the emotion around decision-making and introduce objectivity to your thinking.

In a joint study conducted by psychologists at the Universities of Waterloo and Michigan, participants demonstrated more objective reasoning when they considered the options as choices that someone else had to make. They found that when reflecting on other people's problems, we can better recognize the limits of our own knowledge, the importance of compromise and future change, and consider different perspectives.

This trick can come in handy when it comes to emotional biases when making investing decisions. Take the endowment effect, for instance. This particular bias can lead investors to overvalue an investment, simply because they already own it. There is an emotional attachment and ownership can lead people to hang on to a poor or average investment because they feel it's worth more than what it is in reality.

Think of it like a garage sale you have before downsizing to a smaller home. Most buyers will likely make an offer below your starting price on many items you've put up for sale. With the endowment effect, you may never sell that oversized armoire because your price expectations are unrealistic. The same one could be selling at the second-hand shop for less than you're asking, but you think yours is worth more. This can happen with investing when we place a higher value on our own holdings than what the market is telling us.

But if you were advising a friend or family member, you'd likely change your tune. According to the Waterloo-Michigan study, you might see that the reason for trying to sell the furniture in the first place, such as it's no longer useful or takes up too much space, is more important than obtaining a specific dollar amount.

I used this trick when I was debating lopping off my hair for an edgy, short style, but feared it wouldn't suit me. I took the plunge when I realized I knew exactly how I would counsel a friend: Just do it! You're dreaming about it enough to clearly want it and you won't know how it fits or how you'll like it until you try it. (I admit, it may not be as major a decision as determining where to invest my retirement savings, but certainly tied to self-worth!)

When it comes to investing decisions, distancing yourself from the choices you're considering could just help overcome these limiting biases. By looking at the situation from many perspectives and assessing many outcomes, investors may be able to outsmart those personal biases we sometimes don't even know are at play.