WHY Smart People Make Big Money Mistakes
and HOW to Correct Them
By Gary Belsky and Thomas Gilovich
This book is a must-read for you or a family member if you are interested in making better decisions, both in life and investing. It will provide you with some useful personal insights from the field of behavioural economics.
Here’s a digest of what they had to say:
Suppose you are on a game show and you are given the choice of three doors. Behind one is a new car; behind the other two are goats. You pick a door, say, number one. The game show host opens one of the other doors, say number three, and shows you a goat. He then asks if you would like to change your pick to door number two. What do you do? (See the answer at the bottom of this page)
“Mental accounting” is a term used by behavioural economists and refers to the tendency to value some dollars less than others and thus waste them. One is inclined to categorize and treat money differently depending upon where it comes from, where it is kept and where it will be spent. $100 earned in salary versus $100 won on a lottery ticket versus $100 received from your tax refund should be viewed as the same $100.
However, in fact people tend to separate their money into “mental accounts” and treat dollars differently in these different accounts. This probably serves a useful purpose. But a harmful side effect is that people can value earned income differently to gift income.
“Prospect theory” is the way we frame decisions and outcomes. We may view differently the same decision framed in different fashions.
“Weber’s Law” says that the impact of a change in intensity of a stimulus is proportional to the absolute level of the original stimulus. In financial terms, a $500 gain on a $100 investment is greater psychologically than a $500 gain on a $1000 investment.
For instance, we may view a gain of a certain amount disproportionately to a loss of the same amount.
The asymmetrical view of losses compared to gains in the stock market is precisely what leads investors to selling in a crash. Investing in the stock market is likened to a definition of war: long periods of boredom interrupted by episodes of pure terror. While stock markets seem to rise over the long term, most of those gains are achieved in fits and starts.
A study in 1994 identified that if you had been on the sideline for the 40 best days in the market from 1963 to 1993, your return would have been 7% rather than 12%.
The “sunk cost theory” says that people don’t understand that money already spent should be irrelevant in a decision compared to what must be committed further in order to receive the benefits.
A recent study by the American Stock Exchange found that nearly 40% of young, middle class investors check their investment returns at least once a week. The more you check, the more you will feel urged to act.
“Extremeness aversion” suggests that people will choose the middle selection within a group, rather than one at either extreme end.
Research shows the bias towards the status quo, as when the alternatives were rotated as being the pre-existing holding in the study.
“Regret aversion” supports the status quo. The pain of a negative outcome from a decision is greater than the negative outcome of maintaining the status quo. This is true in the short term but the opposite is found in the long term.
The “endowment effect” says that people place more value on something they own than something owned by someone else, even when the thing is the same.
The “money illusion” ignores the impact of inflation or, more formally, nominal vs real changes. Most people routinely ignore the long term effects of inflation, on the presumption that a little number, like, say 2% inflation, is too small to worry about. People tend to think they are doing better when interest rates are 10-12%, compared to when they are 5-6%. But they don’t look at the real return, which may be higher when rates are only 6%.
“Beware the hot hand” Probabilities are generally misunderstood. Every one knows that, over a large number of tosses, tails will come up 50% of the time. In fact, however, with twenty trials, there is an 80% chance that heads or tails will come up three times in a row, a 50% chance of four times in a row, and a 25% chance of five in a row. Despite this, the odds of getting tails on the next toss are 50%!
“Confirmation bias” explains our tendency to view favourably information we gather which supports our initial impressions. We also deliberately seek to avoid information which may disprove our initial impressions. This has been observed in studies which give comparative feature information sequentially. The choice derived from the first comparative feature biased the analysis of the ensuing comparative features.
“Anchoring” refers to the tendency to latch onto an idea or supposed fact and use it as a reference point for future decisions.
The “planning fallacy” is the inability to complete tasks on schedule.
“Information cascade” sees trends or fads evolve when individuals decide to eschew their own analysis and focus instead on the actions of others, even what that action runs contrary to the individual’s inclinations. Even the smallest bit of new information can lead to rapid and wholesale changes in personal opinions.
Here are some observations on personal financial habits:
1. People integrate losses to bury them
Money poorly spent on a smaller expenditure gets aggregated into money spent on a larger expenditure and thus the smaller error becomes trivialized. Many people are cost conscious on large purchases but flippant with smaller purchases.
2. Larger-size windfalls are treated more reverently than smaller size windfalls.
An economist studied this phenomenon and found that savings rates were quite high for large receipts, but with smaller receipts, the spending rate was even higher than the amount received!
3. Credit card expenditures are cheapened because there is seemingly no loss at the time of purchase.
A research project found that auction bids were twice as high on credit card bids compared with cash bids.
4. Windfall money not spent is invested in honour of the source of the legacy.
Funds received from a deceased’s estate may be invested more conservatively than one’s own savings amounts.
5. When people are asked to choose something, they tend to focus on the relative positive merits of the selections offered.
When they are asked to reject something, they tend to focus on the relative negative aspects of the selections offered.
6. Research suggests that people value pain of loss approximately twice as high as pleasure of gain
7. Research suggests that investors are more inclined to realize a gain than a loss.
That research also showed that the subsequent investments purchased with the proceeds tended to perform poorer than the investment that was sold.
8. The more attractive choices that exist, the more likely is no decision to be made.
And here’s some advice for your decision-making processes:
- Apply due diligence to all purchases, regardless of size
- Defer your decisions for 3-6 months with windfall money
- Treat all cash inflow like earned income
- Re-frame decisions from a neutral, or starting, point, not from the status quo. This will put the pre-existing condition under stronger scrutiny
- Reverse the framing of a decision, from one of “accept” to one of “reject”
- Draw up a quadrant of pros and cons to make sounder decisions for a list of alternatives
- Brand loyalty in support of the status quo often leads to paying a higher price than necessary for the product. The earlier people replace a product, the more likely they are to remain loyal to the brand
- Seek second opinions when making large financial opinions. If you’re lucky, their behavioral economics biases will be different from yours. Don’t ask if they agree with your choice, but ask them to critique your decision-making process
- Comparison shop. When making a decision that you know little about, the more likely you are to pay attention to information that isn’t important, and the more likely you are to anchor on a dollar value that has little basis in reality
- Be humble. We tend to trumpet our successes and forget or not acknowledge our failures. People have an impressive knack for snatching subjective victory from the jaws of objective defeat.
- People frequently confuse familiarity with knowledge. Know the difference.
And here’s some advice for investors:
- Develop a concrete investment philosophy and strategy and put it down on paper. Determine the portion of your portfolio that should be invested in stocks, bonds, real estate and cash. Write it down, along with a notation as to when that allocation should be re-examined. You might also write down the specific rationale for each of your investments. Writing things down “raises the ante” and increases commitment.
- It is arguably more risky to leave yourself open to the risk of inflation by investing in bonds than to expose yourself to swings of the stock market.
- Any individual who is not professionally occupied in the financial services industry and who in any way attempts to actively manage an investment portfolio is probably suffering from overconfidence.
- The forces that move markets and investment prices, at least in the short run, are not directly related to the true worth of the underlying assets. Information cascades cause people to buy because everyone else is buying and sell because everyone else is selling.
- Investors who tune in too closely to financial news probably fare worse than those who tune out the news. The best investors ignore the majority of what passes for important financial news every day.
- One of the smartest ways to evaluate stocks is to focus on those with below average P/E ratios.
The right answer to the game show dilemma is that you should switch your guess to door number 2.
If you got the right answer, you may not need to read this book or book review, although you still may find it useful. If you guessed wrong, here’s why (and read this book and book review!)…
When you picked door number one, the odds were 2/3rds that you picked a goat, and therefore one of the remaining doors has a goat and the other has a car. When you were shown that door number three was a goat, the probability is that door number two has the car. Therefore, you should change your choice… two thirds of the time you would be right. The error is in assuming that your better alternative was not to change your choice, assuming at that point you have a 50% chance of being right.