Book: What Smart People Make Big Money Mistakes and How to Correct Them by Gary Belsky and Thomas Gilovich
This book is like many other in the field of armchair behavioural finance in that it offers little by way of new ideas. That said, it's well worth a browse as it serves as a well written reminder of our biases and is also a pretty quick read.
The authors remind us that we not the rational, optimising decision-makers we often think we are, and that the reality is that we are pretty odd creatures who often take to using use overly simplified programming to make our decisions, which can result in sub-optimal decisions and outcomes. In addition to the all too distorting human factors such as greed, bad habits, guilt, fear and peer pressure, a lot of our choices are framed in ways that latch on to these weaknesses instead of encouraging objective assessments. While the book focuses on the financial side of things, many ideas in this realm of behavioural finance apply equally well to decision making more broadly.
A few scribbles:
- Kahneman and Tversky refer to the simplifying procedures as mental short-cuts or 'judgemental heuristics'. e.g. the instinctive thought that a long line at a restaurant indicates that it is good, or that when buying a house it's a good idea to stretch your budget (peer pressure).
- The Legend of the Man in Green Bathrobe - illustrates an example of mental accounting i.e. valuing some dollars more than others e.g. when you lose money you've won vs money from your wallet. Authors say it is anathema to traditional economics, which holds that money should be 'fungible' (capable of mutual substitution). Similarly for 'gift' money, 'earned' money, money allocated to different actual or mental accounts or moving it from one mental account to another (e.g. tax rebate is earned money but it often goes in the 'found' money pot) ... shouldn't it should be interchangeable?
- Another example of mental accounting: Going to another store to save £5 on a $20 item, but not going to another store to save £5 on a $10,000 item.
- Spending on plastic is very different to spending hard cash. It seems to devalue the money being spent. You end up more likely to spend, and when you do spend, you are more likely to spend more.
- For people who can't control their spending, mental accounting can often be an effective way to ensure the essentials get paid.
- Tip: See the trees for the forest. Break every purchase down to its component parts, and if you wouldn't pay for that component, don't value it.
- Tip: Wait: Sitting on windfall money for a while turns it in to your 'earned' money.
- Tip: Imagine all income is earned income. The best way to train yourself to view all money equally. Ask how long it would take to earn this money after taxes.
- People exhibit a 'status quo' bias, a preference for things to stay as they are.
- People display an inability to forget money that's already been spent (sunk cost fallacy), which makes us more likely to throw good money after bad.
- Loss aversion: Gamblers have a tendency to increase their bets when chance is not going their way. They are willing to take a larger risk to avoid ending up in the red. They feel more strongly about the pain that comes with a loss than they do about the pleasure that comes with an equal gain. Loss aversion can lead us in to holding on to losers longer than we should (it's only a paper loss until its realised), and it makes us more likely to sell our winners too early.
- Don't be fooled into thinking of the stock market as a steadily rising entity. Most of the gains come from a few days in the year. The stock market is like a war, long periods of boredom interrupted by episodes of pure terror. Tip: Focus on the big picture.
- People seem to fall prey to the sunk cost fallacy partly because they don't want to appear wasteful, not necessarily to other people but to themselves (we are our own judges of our finances). e.g. spending more and more money on a knackered car, or terminating a project late in its development. Tip: Forget the past.
- Most people are not keen to admit they suffer from any of this psychological biases.
- The pain of two moderately bad experiences (e.g. tax forms, etc) will typically exceed the pain of experiencing them together. Tip: Do them together.
- 'There are not only sins of commission, but sins of omission as well.' The more choices you face in life, the more likely you are to do nothing > decision paralysis and status quo bias. Tip: Put yourself on autopilot where appropriate e.g. monthly direct debit into a share scheme vs an annual decision.
- Tip: When contemplating decisions, think about the opportunity cost (often there is a better alternative than doing nothing).
- Money illusion: ignoring inflation. It can cloud your vision on the longer horizon, when inflation can comprise the bulk of an asset's gains.
- Odds are you don't know what the odds are. What's the odds of rolling 1,2,3,4,5,6 vs 3,2,4,5,3,3? They are the same. After Jaws came out, less people swam in the ocean. After 9/11 more people in the US travelled by land vs plane. Insurance tip. Insure against the big losses (e.g. house insurance) but not the small stuff such as mobile phones.
- Don't forget survivorship bias. The evidence is that the majority of self-investors lose money.
- People tend to underestimate the role of chance in every day life.
- 10% of funds are likely to beat the average for three years in a row, by chance alone. Past performance is the most common criteria people use to select mutual funds. Tip: Don't be impressed by short-term success.
- Chance plays a greater role than you think. Tip: Play the averages.
- We also tend to disregard the expense ratios.
- Even a blind squirrel finds an acorn once in a while.
- "Anchoring", the clinging to a fact or figure that should have no bearing on your judgements or decisions, is compounded by "confirmation bias", treating kindly information that supports your preferences. (paired with confirmation bias is "disinformation bias", which is when you avoid asking questions that may challenge your preconceptions.) Tip: Get it out paper, make a quadrant and list the pros and cons of the choices.
- Confirmation bias and anchoring is helpful in explaining the old wisdom about first impressions. Once an idea sets in your head, it can be difficult to change.
- These biases distort your impressions subconsciously, more than if you were able to view choices purely objectively, and sales and marketing people exploit this. e.g. seeing a high price selection of goods, and then seeing a cheaper option may make it look like a good deal.
- When it comes to investing in shares, we tend to look at past price highs when assessing whether a stock looks like good value.
- Pulling up an anchor is harder than you might think.
- Tip: Be humble (confidently not knowing)
- Lake Wobegon effect: Garrison Keillor's fictional community where 'all the women are strong, all the men are good looking, and all the children are above average.'
- We need overconfidence for the economy to flourish > entrepreneurs.
- Overconfidence can often lead to the 'planning fallacy', the inability to complete tasks to schedule.
- We don't learn well enough from our mistakes.
- We remember our successes but forget our failures > distorts views on abilities etc. It's a case of 'heads I win, tails it's luck'.
- Tune out the noise.
- Every dollar spends the same.
- Losses hurt more than gains please.
- Money that's spent is money that doesn't matter (i.e. past mistakes shouldn't lead to future mistakes).
- You probably pay attention to things that matter too little (certain facts, figures, etc).
- Your confidence is often misplaced.
- It's hard to admit mistakes.
- The trend may not be your friend.
- You can know too much. Illusory information can be destructive (noise).