My favorite genre of book lately: clear examples of bugs in our brain: where our intuition is wrong. But this one focuses just on money issues. Loss aversion. Sunk cost fallacy. Confirmation bias. Anchoring. Etc. I love this stuff.
One of the most common and costly money mistakes - the tendency to value some dollars less than others and thus to waste them.
This kind of thinking - “I have to be careful with my retirement money” - exposes you to a far more dangerous risk than the short-term ups and downs of the stock market: you run the risk that you won’t have saved enough when your retirement finally rolls around.
You’re prone to wasting money because you wrongly put different values on the same dollars.
Our feelings about loss - called “loss aversion” in psychoeconomic lingo - and our inability to forget money that’s already been spent - termed the “sunk cost fallacy” - make us too ready to throw good money after bad.
In financial matters this phenomenon results in a willingness to take more risk if it means avoiding a sure loss and to be more conservative when given the opportunity to lock in a sure gain.
Gamblers often increase their bets when chance is not going their way; they’re willing to take a bigger risk to avoid finishing in the red.
The difference between earning $10 or $20 for a job well done has a bigger effect on how happy you are than a difference between earning $110 or $120.
Prospect theory says that we assign values to the gains or losses themselves - based on their own merits, if you will, as gains or losses.
It is the actual gaining or losing - and our feelings about it - that matter more to us, rather than how those gains or losses leave us in terms of our overall financial position.
North Korea seems more similar to China than China seems to North Korea.
Although stocks seem to rise steadily over time, they actually do so in major fits and starts - a few big gains on a small number of days sprinkled throughout the year.
By pulling your money out in reaction to short-term drops, you run the risk of missing those productive days.
And it’s a serious risk. According to a study conducted in 1994 by University of Michigan finance professor H. Nejat Seyhun, if you had missed the forty best-performing days of the stock market from 1963 to 1993, your average annual return would have dropped from almost 12 percent, assuming you had stayed fully invested, to slightly more than 7 percent.
The stocks that investors sold outperformed the stocks that they held on to by 3.4 percentage points over the ensuing twelve months.
In other words, investors sold the stocks they should have kept and kept the stocks they should have sold.
And remember, this isn’t an occasional result; it’s a persistent pattern among thousands of investors studied by Odean.
The tendency to hold losers too long and sell winners too soon.
It is, in effect, an extension of prospect theory and loss aversion.
Most people are much more willing to lock in the sure gain that comes with selling a winning stock or fund than they are willing to lock in the sure loss of selling a losing investment, even though it generally makes more sense to sell the losers and keep the winners.
Until you actually sell a losing investment the drop in price is only a “paper loss” - it’s not official.
Once you sell it, though, it’s real.
This, of course, is creative mental accounting at its worst: the unrealized losses are segregated or compartmentalized in a separate account precisely because they’re unrealized.
Loss aversion tells us it is less painful - and more common - to sell winners and keep losers.
Odean’s research says it’s a lot smarter to do the opposite.
Being overly sensitive to loss leads people to opt for a certain gain over one that offers a high possibility of a larger gain.
In real life that usually translates into a preference for fixed-income investments over stocks.
A guaranteed 6 percent or 7 percent annual return from Uncle Sam may seem a lot more appealing than the “chance” to earn 11 percent or more a year in stocks.
But as we’ll see later on, the dangers of the stock market may not be as important as the ravages of inflation.
So to the extent that you opt for “safe” investments - such as bonds, annuities, and other fixed-income or life insurance products - over riskier but generally higher-paying ones, your loss aversion may be costing you a lot of money.
The people who paid more for their tickets ended up attending the performances more often than those who had received discounts.
The more people spent on their tickets, the greater their sunk costs, and the more seriously they took attendance at the plays.
People fall prey to the sunk cost fallacy because they don’t want to appear wasteful.
Not necessarily to other people, mind you; most people act as their own judge and jury
Say you have $10,000 of Microsoft stock that you bought for $5,000, and $10,000 of IBM stock that you bought for $20,000.
Your child’s first-semester tuition bill of $10,000 is due.
Which stock would you sell?
If your answer is the Microsoft, you’re mortal like the rest of us. And your aversion to loss is likely to leave you poorer than you need to be.
(The best strategy, perhaps, might be to sell $5,000 worth of each company’s stock, thus avoiding the need to pay any taxes!)
Stocks on average have returned about 6 percent a year over the past seven decades, adjusted for inflation.
That figure didn’t materialize by virtue of magic or voodoo. During the period in question, corporate profits rose an inflation-adjusted average of about 3 percent annually, while the average stock yielded roughly 3 percent a year in dividends.
You must avoid looking at losses or gains in isolation.
You have to train yourself to view your individual investments as parts of a broader whole.
We spend more money on car repairs because we’ve already spent so much on the car.
We keep spending money on tennis lessons because we’ve already spent so much.
We hold on to bad investments because we can’t get over how much we paid for them and can’t bear to make that bad investment “final.”
Well, get over it. No, we’re not trying to be harsh.
If we could, we’d send you a pill that erases the memory of every dollar you ever spent (except, perhaps, when filling out expense reports and tax returns).
That’s because once spent, it’s gone. It has no relevance (except maybe for refunds).
To the extent that you can incorporate that notion into your financial decisions, you’ll be that much better off for trying.
If you’re debating the sale of an investment (or a home), for example, remember that your goal is to maximize your wealth and your enjoyment.
The goal is not to justify your decision to buy the investment at whatever price you originally paid for it. Who cares?
What counts, in terms of getting where you want to be tomorrow, is what that investment is worth today.
That’s why you must evaluate all investments (and expenses) based on their current potential for future loss and future gain.
The more frequently you check your investments, 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.
For most investors - frankly, for all investors who don’t trade professionally - a yearly review of your portfolio is frequent enough to make necessary adjustments in your allocation of assets.
The more choices people face in life, the more likely they are to simply do nothing.
Tax-deferred retirement accounts are the very portfolios where the risks of investing in stocks are most mitigated: who cares if the short-term value of your 401(k) account goes up and down with the stock market? By the time you’ll need the money - presuming you have at least ten years until retirement - chances are that the roller-coaster nature of equities will be a memory.
The more time you have to do a task - any task - the less pressure you feel to “get with it”.
The decision to invest or not, to spend or not, or to marry or not may be influenced by fear, confusion, or doubt.
Nonetheless, keeping things as they are is a vote of confidence for current circumstances, however weakly that vote may be cast.
In fact, the preference for “holding on to what you got” is a lot stronger than most people think.
The endowment effect leads people to ignore opportunity costs.
A concept that envelops much of prospect theory and its attendant tendencies - loss aversion, the status quo bias, and the endowment effect.
The idea - which behavioral economists call “regret aversion” - is as simple as it sounds.
Most people want to avoid the pain of regret and the responsibility for negative outcomes.
And to the extent that decisions to act - decisions to change the status quo - impart a higher level of responsibility than decisions to do nothing, people are naturally averse to sticking their necks out and setting themselves up for feelings of regret.
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.
People experience more regret over their mistakes of action in the short term, while regrets of inaction are the ones that are more painful in the long run.
Remember: Deciding not to decide is a decision.
Even if a financial decision is not perfect (most are not), it may still leave you in a better position than if you had done nothing.
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.
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.
Reverse the context in which you perceive the choice at hand.
In other words, turn a decision of which option to reject into one of which option to select, and vice versa.
This should help you focus on both the positive and the negative attributes of your options, rather than give disproportionate weight to one or the other. For example, if you’re deciding among investment options and you find yourself unable to choose which one you prefer, ask yourself instead which options you would (in no instance) choose. Or, assume instead that you already own all of the choices. Now your decision becomes which one to sell - which ones you definitely do not want to own.
The hard part is recognizing that your decision is being hampered by the way you’re viewing the problem to begin with.
“Money illusion.” This involves a confusion between “nominal” changes in money (greater or lesser numbers of actual dollars) and “real” changes (greater or lesser buying power) that reflect inflation or, more rarely these days, deflation.
That’s the irony of a so-called conservative investment strategy: it is arguably more risky (and reckless) to leave yourself vulnerable to the ravages of inflation than it is to subject yourself to the hills and valleys of the stock market.
Failing to take small numbers seriously can have profound effects when stretched out over time. It’s one thing to tack on a $500 stereo when you’re buying a $12,000 new car; such things happen infrequently enough. But it’s another thing to incur small expenses or small losses repeatedly over a long period; such things add up.
The expense ratio tells you how much the fund operator will subtract from your account every year.
Some hard-and-fast rules you can live by that will help you overcome the problems that number numbness may present. Don’t be impressed by short-term success.
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.
Steer clear of funds that charge more than 1 percent or so in annual expenses.
“Confirmation bias.” This bias consists of a tendency to search for, treat kindly, and be overly impressed by information that confirms your initial impressions or preferences. Coming at this from the other direction, it could also be called a “disconfirmation disinclination,” because it is paired with a tendency, once you get an idea in your head, to avoid asking questions that may challenge your preconceptions.
Write out the pros and cons of each option. Benjamin Franklin, in fact, recommended just such a procedure. But many find the exercise unhelpful. They frequently stop midway and exclaim, “This isn’t coming out right. It’s not favoring the one I want!” A preference they didn’t know they had suddenly asserts itself and does away with a procedure that would lead to the “wrong” decision. The confirmation bias can affect almost any decision you make. Once you develop a feeling about an issue - no matter how unconscious that preference might be - it becomes that much harder to overcome your bias.
Mercedes “loyalists” paid an average of $7,410 more for their new cars than did buyers who switched to Mercedes from another make.
We can’t stress enough that you are particularly prone to anchoring on a particular dollar figure when you’re swimming in unfamiliar waters.
Because people’s natural bias is to confirm what they already “know” or think they know, they reflexively try to prove a rule by looking for facts that would support it rather than looking for information that might contradict.
Confirmation bias can be summed up with a simple statement: People often hear what they want to hear.
Broaden your 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. True, they may fall victim to the same bad habits as you. But maybe their mental bugaboos are triggered by other factors than yours, and anyway, it’s a lot easier to recognize someone else’s problem than your own. 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.
Throughout the world, most investors own more stock of companies in their own country than of those in foreign countries.
A psychological need on the part of investors to feel comfortable about their investments, with that comfort coming from familiarity.
People overconfidently confuse familiarity with knowledge. For every example of a person who made money on an investment because she used a company’s product or understood its strategy, we can give you five instances where such knowledge was insufficient to justify the investment. A classic example is Apple.
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.
If you are a person who’s prone to kicking yourself for investment opportunities that you missed, we suggest you undertake the following exercise. For at least a month, write down every investment idea that you have, then tuck that paper away in a drawer somewhere. In about a year take it out and see how all your picks have done. We suspect that while several will have outperformed the market, an equal or greater number won’t. Again, this is a useful and interesting way to avoid succumbing to fond memories.
A helpful way to deal with overconfidence is to incorporate an “overconfidence discount” into your projections, both on the upside and on the downside.
Large trends or fads begin when individuals decide to ignore their private information and focus instead on the actions of others, even if that action conflicts with their own knowledge or instincts.
Investors who received no news performed better than those who received a constant stream of information, good and bad. In fact, among investors who were trading the more volatile stock, those who remained in the dark earned more than twice as much money as those whose trades were influenced by the media.
“Extreme returns of stocks listed on the New York Stock Exchange were found to be subsequently followed by significant price movement in the opposite direction. Using ten-year blocks of time, loser portfolios earned from the beginning to the end of the five-year holding periods an average of 30% more than the winner portfolios. Using the same procedure with six-year blocks of time, losers outperformed winners by almost 25% during the three-year holding periods.”
Let’s restate that in simpler terms. Thaler and De Bondt showed that when investors react in extremes - remember, they looked at stocks whose prices bounced up or down in excess of the movements of the typical NYSE share - those reactions will likely be reversed over time.
When a company’s stock price is dampened by pessimistic investors, odds are it will bounce back. Conversely, when a firm’s share price is inflated by overly optimistic buyers, odds are it will fall back. It’s an example, once again, of regression to the mean - the idea that extremes tend to revert back to something closer to the average. But it’s also a reminder that the crowd is often wrong.
An entire school of investing is based on the premise that over short periods the market is often misguided but over the long run true value will win out.
This school - called “value investing” - counts among its “graduates” some of the best investment minds in history, including Benjamin Graham, Warren Buffett.
Identifying companies that are out of favor with investors for any number of reasons, none of which has to do with their core business prospects.
Financial fads are a lot like buses: there’s no sense running after one, since another is certainly on its way.
Beginning your search for appropriate investments by focusing on those investments that the general public has turned its back on.
One of the smartest ways to evaluate stocks - if you’re determined to do so - is to focus on those with below average price-to-earnings ratios, or P/Es. A P/E is simply the ratio between a stock’s price per share and its profits per share.
It’s important that you learn to view all money equally - salary, gifts, savings, even lottery winnings.
Past mistakes shouldn’t lead you to make future ones. The past is past, and what matters is what is likely to happen from now on.