Why Smart People Make Big Money Mistakes By Gary Belsky

Why Smart People Make Big Money Mistakes And How To Correct Them- Book Summary

Why Smart People Make Big Money Mistakes

What is consistent about the man who thinks saving $5 is sufficiently worthwhile to drive twenty minutes to a discount grocery store, but who throws away hundreds of dollars a year on the gas-guzzling car used for the trip? The minds of typical consumers, savers, borrowers, spenders, and investors. That’s who this book, Why Smart People Make Big Money Mistakes is for.

Not All Dollars Are Created Equal

 “Mental accounting,” coined by Richard Thaler, underlies one of the most common and costly money mistakes: the tendency to value some dollars less than others and thus waste them. More formally, mental accounting refers to the inclination to categorize and handle money differently depending on where it comes from, where it is kept, or how it is spent.

Money in particular, should be fungible: That is, $100 in roulette winnings, $100 in salary, and a $100 tax refund should have the same significance and value to you.

If money and wealth are fungible, there should be no difference in the way we spend gambling winnings or salary. Every financial decision should result from a rational calculation of its effect on our overall wealth.

By assigning relative values to different moneys that in reality have the same buying power, you run the risk of being too quick to spend, too slow to save, or too conservative when you invest —all of which can cost you.

Mental accounting helps to explain one of the great puzzles of personal finance—why people who don’t see themselves as reckless spenders can’t seem to save enough.

Although many people are cost-conscious when making large financial decisions— such as buying a house, car, or appliance—mental accounting makes them relax their discipline when making small purchases. The cost of such purchases gets lost among larger expenses, such as the week’s grocery bill, or charged against a lightly monitored “slush fund” account. The problem, of course, is that while you might purchase a car or refrigerator every few years, you buy groceries and clothes and movie refreshments every week or every day. Being cost-conscious when making little purchases is where you can often rack up big savings.

Table of Contents

You may be prone to mental accounting if you…

  • you don’t think you’re a reckless spender, but you have trouble saving.
  • have savings in the bank and revolving balances on your credit cards.
  • you’re more likely to splurge with a tax refund than with savings.
  • you seem to spend more when you use credit cards than when you use cash.
  • most of your retirement savings are in fixed-income or other conservative investments.

Before you spend that windfall money train yourself to wait awhile before making any spending decisions.

Imagine that all income is earned income thisis the best way to train yourself to view all your money equally. Basically, the trick is to ask yourself how long it would take you to earn that amount of money after taxes.

Our feeling about loss is called “loss aversion” in behavioral economics lingo and our inability to forget money that’s already been spent is called the “sunk cost fallacy”. Sunk cost fallacy makes us too ready to throw good money after bad.

Tendency to fall in love with what we own (the “endowment effect”) to make us resist change. A deeper understanding of both concepts should lead you to better investment and spending decisions.

Oversensitivity to loss can also have negative consequences.

Good Money After Bad

“Sunk cost fallacy.” This psychological trap is the primary reason most people would choose to risk traveling in a dangerous snowstorm if they had paid for a ticket to an important game or concert, while passing on the trip if they had been given the ticket for free.

You might be a victim of loss aversion or the sunk cost fallacy if you …

  • make important spending decisions based on how much you’ve already spent.
  • generally prefer bonds over stocks.
  • tend to sell winning investments more readily than losing ones.
  • you’re seriously tempted to take money out of the stock market when prices fall.

Make Wise decision

  1. Investing in individual stocks is not only fun, it can be profitable and educational. Put no more than 10 percent of your nest egg into stocks of individual corporations. The rest should be spread out over other kinds of investments.
  2. Diversify. The best way to avoid the pain of losing money, of course, is to avoid losing money. We haven’t figured that one out yet, but there are ways to minimize investment losses. One of the best is diversification.
  3. Follow the Law of Five Years. Stock prices can bounce up and down violently, sometimes staying down for years at a time. That’s why any money you’ll need within the next five years should be removed from stocks and put into cash or cash equivalents like government bonds.
  4. Heed the Rule of 100. If you’re, say, eighty-four years old, about 16 percent of your long-term nest egg (100 – 84 = 16) should be in stocks (preferably through an index mutual fund or two).
  5. Forget the past. Very often our decisions about the future are weighed down by our actions of the past. People stay in unsatisfying careers because of the time and money they invested in school, not because they enjoy the work or expect to in the future. The same motivations affect our decisions about money: We spend more money on car repairs because we’ve already spent so much on the car.
  6. Pay less attention to your investments. The more frequently you check, the more you’ll notice—and feel the urge to react to—the ups and downs that are an inevitable part of the stock and bond markets

Too Much Of A Good Thing

One important result of decision paralysis in financial choice is that by deferring buying decisions, you may miss a sale entirely or run the risk that prices will rise.

Knowingly or not, you probably pay good money all the time to avoid feelings of regret or to otherwise maintain the status quo. Leaving money in a bank account rather than putting the cash in an investment with a higher return; staying in a relatively low-paying job rather than making a switch to one with a higher salary; failing to sell an investment only to see it drop in price (selling it with the crowd only to see it rise); delaying a purchase only to see the price rise; All of these inactions are examples of the ways that regret aversion, decision paralysis, and the status quo bias combine to influence your financial decisions and to cost you money.

You might suffer from decision paralysis if you…

  • have a hard time choosing among investment options.
  • don’t contribute to retirement plans at work.
  • tend to beat yourself up when your decisions turn out poorly.
  • frequently buy things that offer “trial periods”—but infrequently take advantage and return them.

To avoid decision paralysis keeps these in mind:

  1. Choose fewer choices.
  2. Remember: deciding not to decide is a decision. Postponement, delay, procrastination. They may seem like the path of least resistance, but a passive approach to decision making can be as consequential as any other choice.
  3. Don’t forget opportunity costs.
  4. Put yourself on autopilot. Instead of having to make an endless series of decisions about whether now is a good time to invest, use dollar cost averaging. This is a strategy that involves investing a set amount of money at regular intervals in a stock or bond or mutual fund—regardless of whether the markets are rising or falling.
  5. Make deadlines work for you.  Advice for decision paralysis sufferers—have deadlines.
  6. Play your own devil’s advocate. Approach decisions from a neutral state. In other words, force yourself to imagine that you’re starting from ground zero rather than from a status quo position.
  7. If you’re not an expert, ask one.
  8. Know when time is on your side and when it isn’t. This is just our way of reminding you that it’s too easy to overlook the deleterious effects that time, in the form of inflation, can have on buying power and to remind you that stocks have proven to be the best way to maintain buying power, given their long history of far outpacing the general rise in consumer prices.
  9. Read the fine print. If you invest in mutual funds, pay close attention to their fee structures, which are clearly outlined in the prospectus that fund operators are bound by law to send you before they take your dough.

Dropping Anchor

 “Preferential bias” It means that once people develop preferences—even small ones—they tend to view new information in such a way that it supports those preferences. Or, barring that, they tend to discount any new information that doesn’t fit their preconceived opinions and feelings.

Once an idea sets in your head, it often sets in concrete; you can break it, but you may need a sledgehammer. In fact, we’d guess that confirmation bias might have a lot to do with the commonly held retailing wisdom that shoppers usually end up buying the first item they look at when they are out shopping.

The power of suggestion

People can be susceptible to anchoring even when they are especially knowledgeable about the subject at hand—and therefore presumably less likely to be influenced by facts that might sway those with less experience.

Anchoring can influence almost any financial decision you make, even when you have some expertise about the issue at hand and even when you know the anchor value was chosen to take advantage of you. When making money decisions in areas in which you have little expertise, anchoring can trip you up on either side of a transaction.

You may be prone to the confirmation bias or anchoring if …

  • you’re especially confident about your ability to negotiate and bargain.
  • you make spending and investment decisions without much research.
  • you’re especially loyal to certain brands for mindless reasons.
  • you find it hard to sell investments for less than you paid.
  • you rely on sellers to set a price rather than assessing the value yourself.

Bias is something that plagues other people’s judgments. That’s why our first piece of advice is this:

  1. Broaden your personal board of advisers. We can’t stress enough the importance of getting a second opinion, of conferring with other people when making large financial decisions.
  2. When in doubt, check it out. The less knowledge you have about a subject, the more likely you are to pay attention to information that really doesn’t matter when making decisions that really do—the more likely you will be to anchor on a dollar value that has little basis in reality. That’s why it’s important to comparison shop—not so much to find the best price as to find the correct starting point of reference. Learn to disregard meaningless information, such as the price you paid for something originally when you are selling something.
  3. Get real. In reality, over the long run stocks have returned about 9 percent a year, bonds about 5 percent.
  4. Be maximally aware of minimum payments.
  5. Finally, be humble, so that you recognize when you have been wrong.

The Ego Trap

You’re probably not as smart as you think you are. That’s okay; neither are we. Few people are. Overconfidence is pervasive, even among people who presumably have good reason to think highly of themselves.

Overconfidence is not always arrogance; even if you already think you’re a lousy shopper, you might be worse than you think.

Overconfidence comes in many flavors, one of them unwarranted optimism.

It is this overconfidence that makes gym goers pay annual membership, it is overconfident about their willpower or commitment to fitness, they overestimated the frequency of their future gym visits. They end up visiting gym less often than they had predicated. In long run they waste a lot of cash. They would have been better off, financially, had they chosen to pay per workout rather than signing up for monthly or annual memberships.

Read more on this in The Paradox of Choice, very similar to Why Smart People Make Big Money Mistakes.

All Too Familiar

Invest-in-what-you-know approach is at least partly responsible for the fact that employees typically allocate more than a third of their retirement account assets to the stock of the company for which they work, despite the risks of such a strategy: Your biggest investment—your job—is already tied to the fortunes of your workplace, so by stashing retirement assets in company stock, you’re putting too many eggs in one basket. That’s why most financial planning pros recommend you keep no more than 10 percent of your 401(k) assets in your own company’s shares.

Overconfidence may cost you money if you…

  • make large spending decisions without much research.
  • take heart from winning investments but “explain away” poor ones.
  • think selling your home without a broker is smart and easy.
  • favor package deals and annual memberships over à la carte pricing.
  • don’t know the rate of return on your investments.
  • you believe that investing in what you know is a guarantee of success.

Remedies to Overconfidence

  1. Investor, know thyself. Maybe you are as good an investor as you think. But experience tells us that many people overestimate their hit-to-miss ratio, either because they conveniently ignore or explain away their failures or because they don’t do a full accounting when calculating their performance records (most often both).
  2. Take 25 percent off the top, add 25 percent to the bottom. Nonetheless, a helpful way to deal with overconfidence is to incorporate an “overconfidence discount” into your projections, both on the upside and on the downside.
  3. Ask three good questions. Which three questions? We don’t know, but they usually begin with “Why?” “Why this particular investment?” You need a system to help you overcome your own self-confidence.
  4. Get a second opinion.

Point To Ponder.

  1. Too much choice makes choosing tough.
  2. The trend isn’t always your friend. The challenge in taking counsel from others is not to abandon completely your own instincts, common sense, and reason. Herd investing is just one example of the tendency to base decisions on the actions of others.
  3. You can know too much. Knowledge is power, but too much information can be destructive. Studies have shown that investors who tune out the majority of financial news fare better than those who subject themselves to an endless stream of information, much of it meaningless.
  4. Self-insure against small losses. The sensitivity to experiencing losses also leads people to take out insurance policies they do not need and that are not in their best interests. If your car was bought on credit, for example, by all means take out a collision and comprehensive policy to insure against damage. If you paid cash for it, however, you’re better off just paying for liability coverage.
  5. Pay off credit-card debt with emergency funds. This sounds reckless, but it’s not, and it can save you big bucks. Here’s the math: A lot of people have money stashed for a rainy day. By treating that money as untouchable, however, they typically keep it in ultrasafe bank accounts or money market accounts.
  6. Switch to index funds.
  7. Diversify your investments.
  8. Max out your retirement plan.

Why Smart People Make Big Money Mistakes And How To Correct Them: Lessons From The New Science Of Behavioral Economics by Gary Belsky & Thomas Gilovich was published Simon & Schuster; Fireside Ed edition (April 6, 2000). 224 pages.

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