Magical Thinking: Impact on Financial Distress, Decisions, and Behavior

By Dr. William “Marty” Martin
    During times of distress, it is normal and adaptive to believe that you can affect a situation or circumstance even though you know deep inside that you have absolutely no control. Reflect for a moment about high-performing star athletes who go to bat with their “lucky rabbit foot” believing magically that the “lucky rabbit foot” will cause them to hit more baseballs and run to home plate more often. In reality, we all know that the “lucky rabbit foot” does not actually cause the outcome of the game to change.

    Do investors also engage in magical thinking by believing that if they do or don’t do something that this will influence the randomness in the stock market? Let’s look at five examples of magical thinking, bearing in mind that these are just the tip of the iceberg.

1. As an investor, you diversify among different financial advisors believing that this will reduce your risk, but not knowing if the asset allocations are the same or different among the diverse financial advisors. In short, you diversify your financial advisors rather than your portfolio.
2. As a partner/spouse in a committed relationship, you dare not talk about money believing that this will make the tension about money differences/styles between the two of you go away.
3. As an aspiring retiree, you keep your investments on auto pilot believing that if you don’t mess with them, then everything will be alright.
4. As a client of a stockbroker, you accept his/her stock recommendations believing that they are not subject to the same cognitive mistakes and emotions (such as fear and greed) as you are because they are well-educated and trained.
5. As a worker, you believe that your merit increase or the raise from your promotion will get you further ahead on your savings plans not realizing that your expenses may go up along with your increase in income and thereby wash out your ability to save.

    Magical thinking is not necessarily bad or good. Rather, it is adaptive, particularly in situations with a high degree of uncertainty, unpredictability and ambiguity such as 2011 in general and August /September of 2011 in particular. In essence, it is a coping mechanism. However, it is not a functional coping mechanism if it is the only coping mechanism used, or if it is used far more than any other coping mechanism such as facing reality—even if reality stinks.

    What can you do if you engage in magical thinking more than you would like? First, congratulate yourself for admitting that this is your reality. Second, know that you are not alone and stay away from individuals who engage in the same type of magical thinking about the same issues. Because both of you may distort reality and collaborate in a shared delusion. Simply because somebody else shares your magical thinking does not make it any less magical. Third, gather as many facts as possible and different perspectives from different individuals to challenge your cause & effect theory that is operating in your head. Fourth, accept the reality that some threats are manageable and some threats are not and that is normal and OK. Fifth, review past decisions and behaviors that didn’t turn out well and ask yourself if magical thinking was the source of those decisions and behaviors.