Introducing a Rational Way to Avoid Financial Disasters

In 1996, Alan Greenspan used a two-word phrase in a speech, and stock markets around the world began to drop.

The two-word phrase was "irrational exuberance." Greenspan was famous for purposely making his words hard to understand, but in this case, the message was clear. Stocks around the world appeared to be overvalued, especially in the United States.

In fact, it was the start of the Dot-Com bubble. Millions of amateur and professional investors alike piled into the NASDAQ hoping to make a fortune on brand new Internet companies--many of which had never earned a dime.

But then the bubble burst, and people lost a fortune instead. The same thing happened again with the housing bubble in the 2000's, which temporarily dropped the DOW by 54%.

When it comes to investing, irrational exuberance is a fact of life. It will always be a part of investing, but you don't have to be a part of it.

Take Off the Rose-Colored Glasses

On my first real estate deal, I made a 100% return in 3 months. Annualized, that's a 400% return. And that was the worst thing that could have happened to me, because now I thought it was super-easy to make money in real estate--even though I knew it wasn't my strength.

So I quickly abandoned Strengthsvesting. I quickly abandoned due diligence. And I jumped on board the irrational exuberance train, where every passenger is wearing rose-colored glasses on the way to pick up their fortune.

Instead of calculating the risks, you're romanticizing the rewards. It's irrational, it's exuberant and, for me, very costly once I discovered real estate doesn't match my strengths.

Now I Have a New Way to Battle Irrational Exuberance

Investors are limited by what behavior psychologists call Bounded Rationality: we have limited information, we have limited cognitive ability including mental biases, and we have limited time to make a decision.

Due diligence is about recognizing these limitations, and making a plan to mitigate them as much as possible.

My plan starts with my wealth team. I have a number of different people working with me that can minimize my limitations and keep me rational.

I have an attorney to look at the details of any investment opportunity and assess what risks are involved.

I have a CFO look at my current cash flow and my cash position to determine if the deal makes sense at that time. He also has a vetting process to look further into the person promoting the opportunity.

I have an investment advisor who analyzes the investment and assesses the risk--and who knows me well enough to say whether the investment fits my strengths.

By putting together a team like this, you're fighting that first limitation of Bounded Rationality, which is limited information. Putting all your heads together increases your knowledge and can help you make a better decision.

It also helps you fight cognitive limitations, the second part of Bounded Rationality. Emotions come into play with investing, and that can stop you from using your brain effectively. You may also have built-in mental biases that keep you from seeing things clearly. So having other brains involved--with different emotions and mental biases--helps minimize this limitation.

Having a team look over an investment before I pull the trigger also helps fight the last bounded rationality limitation, which is time. Connecting with every other member of the team forces me to slow down and not make any quick decisions.

Oftentimes salesmen push you to act right away to get in on the "opportunity," but that's usually a good sign that you shouldn't get involved at all.

Yes, you may miss a few opportunities by not acting fast. But you'll also save yourself a lot of regret and lost money by not acting recklessly.

You can steer clear of irrational exuberance and fight Bounded Rationality by putting together your own wealth team--or utilizing a team like we've put together at Wealth Factory.

In the end, if you have any doubt, the best thing to do is usually to say "no." If you trust your gut, stick to your strengths and do your due diligence, the right opportunities will come along.