‘Why Smart People Make Big Money Mistakes And How to Correct Them’ is a book on behavioral economics written by
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Here are some of the important excerpts from the book. Hope it is helpful.
Important Excerpts from the Book: ‘Why Smart People Make Big Money Mistakes’
The flight instructors, who were taking a class that Kahneman taught argued against the conventional wisdom that rewards were a more effective teaching tool than punishments. Rather, the officers found that when a pilot was praised for a good flight he tended to do worse the next time in the air, while pilots who were criticized after a poor performance routinely did better next time they flew.
Readers familiar with statistics probably recognize the flaw in the officers’ conclusions and in their theory of motivation. In the nineteenth century, a British scientist named Sir Francis Galton introduced a concept called “statistical regression.” He explained how in any series of uncertain event that tend to fall around an average or mean. Kahneman recognized that any single performance by a pilot-good or bad- would likely have been followed by a flight that moved closer, or regressed, to that pilot’s long-term average. So the pilots who were criticized for a poor flight were more likely to do better the next time regardless of what their instructors did, while those who had received compliments were statistically more likely to do worse on their next flight.
Mental accounting refers to the inclination to categorize and treat money differently depending on where it comes from, where it is kept, or how it is spend. Imagine that you’ve bought a ticket to the Super Bowl or a hit Broadway play. At the stadium or theater you realize you’ve lost your ticket, which cost $150. Do you spend another $150 to see the game or performance? Now imagine the same scenario, but you’ve planning to buy the $150 ticket when you arrive. At the box office, you realize you’ve lost $150 somewhere in the parking lot. Still, you have more than enough in your wallet to but the ticket. Do you?
If you’re like most people, you probably answered “no” to the first question and “yes” to the second, even though both scenarios present the same dilemma: a loss of $150 and the subsequent prospect of spending. For most people the first scenario somehow translates into a total entertainment cost of $300- two actual tickets, each costing $150. This might be too much, even for a Super Bowl or hit play. Conversely, for most people the loss of $150 in cost in cash and the $150 cost of the ticket are somehow separated- mentally- into two independent categories or accounts. They are unfortunate but unrelated. This type of thinking- treating two essentially equal $150 losses in very different ways because they occur in different manners- is a classic example of mental accounting.
Imagine that you go to a store to buy a lamp, which sells for $100. At the store you discover that the same lamp is on sale for $75 at a branch of the store five blocks away. Do you go to the other branch to get the lower price? Now, imagine that you go to the same store to buy a dinning room set, which sells for $1775. At the store you discover that you can buy the same table and chairs for $1750 at a branch of the store five blocks away. Do you go to the other branch to get the lower price?
Once again, studies tell us that more people will go to the other branch to save on the lamp than would travel the same distance to save on the dinning room set, even though both scenarios offer the same essential choice: Would you walk five blocks to save $25?
Imagine that you have just been given $1000 and have been asked to choose between two options. With option A you are guaranteed to win an additional $500. With option B you are given the chance to flip a coin. If it’s heads, you receive another $1000; tails, you get nothing more. Which option would you choose?
Now imagine that you have just been given $2000 and are required to choose between two options. With option A you are guaranteed to lose $500. With option B you given the chance to flip a coin. If it’s heads, you lose $1000; tails, you lose nothing. Now which option would you choose?
Once again, research suggests that more than likely you chose option A in the first scenario ( the sure gain of $500 ) but option B in the second (an even chance to lose $1000 or nothing at all). And, again, the final outcome in both versions, for both options A and B, is the same. With option A- the sure gain in the first version or the sure loss in the second- you end up with $1500 in either scenario. With option B you have an even chance of winding up with $1000 or $2000 in the both the first and second scenario. But by choosing option A in the first case and option B in the second, you once again show that you’re willing to take more risk if it means avoiding losses and to be more conservative when given the opportunity to lock in sure profits. This outlook, by the way, is one of the reasons 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.
Weber’s law implies that people will be cautions when dealing with potential gains. The difference between nothing and $500 is greater psychologically than the difference between $500 and $1000, so most people want to lock in the sure $500. The same law, however, implies a greater tolerance for risk when dealing with potential losses. Again, the difference between losing $500 and losing nothing is greater psychologically than that between losing $500 and losing $1000. Why not expose yourself, then, to the risk of losing that last (relatively unimportant) $500 in exchange for the possibility of sustaining no loss at all?
Getting back to people’s emotions about gaining versus losing money, what’s important to understand is that, according to prospect theory, people feel more strongly about the pain that comes with loss than they do about the pleasure that comes with an equal gain. About twice as strongly, according to Kahneman and Tversky, meaning that people feel the misery of losing $100( or $1000 or $1 million) about twice as keenly as they feel the pleasure of gaining a like amount. That’s why you you are likely to choose the sure gain of $500 in the first scenario but reject the sure loss of $500 in the second, even though both would leave you with $1500. The idea of losing $500- for certain- is so painful that you’re willing to take a risk of winding up with a mere $1000 simply to avoid that discomfort. Similarly, in a sort of mirror effect, the idea of letting that $500 gain in the first scenario slip away, for the chance of maybe winding up with a $1000 gain, is discomfiting enough to cause you to opt for the sure thing.
Loss aversion doesn’t affect only securities investments. A woman Gary knows bought a condo in Boston in the late 1980s for $110000, just before the real estate market in the Northeast collapsed. A year later, when her job forced her to move to another city, the highest offer she received for her place was $100000. She passed, less because she thought the real estate market would improve than because she was unable to face the prospect of taking a $10000 loss. Instead she leased an apartment in Los Angeles while simultaneously renting out her Boston home. Eventually, though, she was forced to sell her condo when she decided to buy a home in Los Angeles. Her selling price: $92000. No need to wonder why an overdeveloped fear of losses can lead anybody to make financial decisions that are not in their best interest.
It’s a fact that individual investors tend to sell winning investments too quickly and keep losing ones too long. Investors were in the fact more likely to sell stocks that had risen in price rather than those that had fallen.
The argument for this sort of reasoning would be that the winners have already had their run, while the losing stocks have yet to make their move. It’s a version of the regression theory. The seaworthy boats (which had their trailwind of good fortune) are due to spring some leaks, while it’s about time the leaky boats become more secure. So, better to sell the good boats now before they sink. Obviously no sailor in his right mind would behave in the fashion, yet many investors do so routinely.
Most people are much more willing to lock in the sure gain that comes with selling a winning stock or find than they are willing to look in the sure loss of selling a losing investment, even though it generally makes more sense to sell the losers and keep the winners. The prospect of selling that losing investment (and the pain associated with making the loss final) makes them more willing to dig in their heels and take risks- the risk, of course, being that if they hold on to the losers, the investment will continue to drop in price. After all, 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. Thus you can ignore them (or treat them as a potential future gain) and they don’t disprove your investing “prowess.”
Just because stocks have been a great investment for seventy years doesn’t mean they will be a great investment in the future. They could be, most certainly, but there’s no way to know. Past performance really is no guarantee of future results, or even a very reliable gauge.
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 of they enjoy the work or expect to in the future; we finish a bad book because we’ve already gotten so far, not because we’re anxious to see how the characters live; we sit through a boring movie because we bought the ticket, not because it’s a good flick. We spend more money on car repairs because we’ve already spend so much on the car. 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.”
Suppose, a stock you purchased for $100 a share is now selling for $25 a share. If you believe that lower price is a bargain, hold on and maybe even buy more shares. But if it is not- if, given the chance, you would pass on the opportunity to buy the same shares at any price today- then it is time to sell. So ask yourself when evaluating investments: “Would I buy this today, at this price?” If not, you may not want to own it any longer.
Some of the more serious and costly financial mistakes people make are the result of inaction. It’s not always what you do that hurts your pocketbook, but what you choose not to do. The fear of regret and a preference for the same old thing- contribute to a phenomenon that we like to call “decision paralysis”.
The preference for “holding on to what you got” is a lot stronger than most people think. People tend to overvalue what belongs to them relative to the value they would place on the same possession or circumstance if it belonged to someone else. This is known as “endowment effect”.
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; delaying a purchase only to see the price rise; keeping revolving balances on a high-rate credit card rather than switching to one with lower finance charges; 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.
People experience more regrets over their mistakes of action in the short term while regrets of inaction are the ones that are more painful in the long run. The evidence thus reinforces the wisdom of Mark Twain, who said, “Twenty years from now you will be more disappointed be the things you didn’t do than by the ones you did do.”
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. In this way you end up buying fewer shares when the price of an investment is high and more when the price is lower. Similarly, people who have trouble controlling their spending can have their mortgage payment- most any payment, really- deducted from their bank account so they’ll never have to “choose” between making a loan payment or spending that money on something else.
Steve, a thirty-year-old American, has been described by a former neighbor as follows: “Steve is very shy and withdrawn, invariably helpful, but with little real interest in people or the social world. A meek and tidy soul, he has a need for order and structure and a passion for detail.” Which occupation is Steve currently more likely to have: that of a salesman or that of a librarian? Most would say he is a librarian. But you would be more right if you say that he is a salesperson.
There are more than 15 million salespeople in the United States, but only 180000 librarians. Sure, a neighbor described Steve in a way that seems to make him unsuited for a life sales, but one person’s opinion hardly outweighs the fact that, on statistical grounds Steve is eighty-three times more likely to be a salesman than a librarian. And while most people don’t have easy access to Bureau of Labor Statistics data, the notion that salespeople far outnumber librarians is probably patently obvious to you- as is the idea that among the millions of people in sales, there are probably hundreds of thousands or more who don’t match the conventional image of that more people tend to be in sales.
Even with lotteries, though, it is tough to get a good grasp of how hard the odds against you really are. For example, in a lottery in which six numbers are selected out of fifty, what are the chances that the six numbers will be 1,2,3,4,5, and 6? Most people would say that such an outcome “is never going to happen,” which, although an exaggeration, does capture the long odds against such an occurrence. It is important to note, however, that the odds of 1 through 6 being selected are the same as the odds of any six numbers being selected. It doesn’t seem right, but it is.
Another reason it can be difficult to get an accurate picture of the true probabilities is that exceptions to the overall odds are often more easily called to mind. That’s why so many would-be swimmers avoided the beach after the movies Jaws came out in 1975. Though fewer than seventy shark attacks had occurred in U.S. waters during the previous decade and despite the fact that the odds against being attacked by a shark were enormous- Americans were inordinately terrified of toothly predators that summer. That’s also why, after the stock market crash of 1987, many investors stopped investing in stock mutual funds for the next eighteen months or so, opting instead for cash or bonds. These folks ignored the base rate- the overwhelming historical evidence that stocks significantly outperform bonds- and focused instead on a memorable event that was more easily called to mind but highly anomalous.
Imagine you’ve the coach of a basketball team. There’s ten seconds left in the game and your team is down by a basket. Your star player, who over the course of his five-year career has made 55 percent of his shots, is only two for ten on the night, missing several wide-open jump shots. Another veteran player on your team has made his previous ten shots, even though his five-year career shooting percentage is just 45 percent. To whom would you give the ball for the last shot of the game?
Regardless of how many shots a player has made or missed in a row, the odds that he will make or miss his next shot are the same as you would expect from his overall, career-long shooting average. That is, a 55 percent career shooters is more likely to hit any given shot, regardless of his previous short-term history, than is a 45 percent shooter, regardless of his previous short-term performance.
One way to understand the myth of the hot hand is to think of a series of coin flips. The odds that a coin will come up heads on any given flip 50 percent; there’s a one in two chance. Most people know this. Yet if you flip a coin twenty times in a row- try this at home; it’s safe- there is an 80 percent chance that you will get three heads or three tails in a row at some point during the series. There is also a 50 percent chance of getting point in the series, even after several heads in a row, the odds that the next flip will be heads are exactly the same as they ever were- 50 percent.
It is true that some mutual funds outperform their peers and the markets in general over time because the funds’ managers have superiors investment skills. But it is also true that no formula has been found to identify those brilliant managers (who are a rare breed indeed: over periods of decade or more, roughly three-fourths of all stock funds will underperform the market). More important, it’s also true that past performance, at least in the short run, cannot be counted on as an indication that the mutual fund is being run by an above average manager. The fact of the matter is that even bad fund managers will, by dint of chance, “come up heads” several years in a row- that is, they’ll enjoy a prolonged series of investment successes that are just as much a function of luck as skill. In fact, University of Wisconsin finance professor Werner De Bondt estimated that more than 10 percent of stock mutual funds are likely to beat the average performance of the average equity fund fund three years in a row, just as a matter of chance. Even a blind squirrel finds an acorn or two once in a while. Even a lousy mutual fund manager will make a few smart investments every now and then.
Don’t be impressed by short-term success. There are many reasons not to chase after last year’s hot investment, be it a mutual fund, or the stock-picking success of a particular brokerage firm. But the most important reason is that there is no earthly way of discerning if one year’s performance is meaningful at all. It may simple be a matter of luck. Indeed, even a ten-year record of above average performance may reflect nothing more than one or two years of random success amid otherwise lackluster results. So when evaluating investments such as mutual funds or annuities, don’t be swayed by one or two years of strong results. Even when you look at long-term performance, pay careful attention to year-by-year results. We’re at least somewhat willing to believe that ten years of leading the pack is less a matter of luck than skill. But watch out: the people responsible for the ten years of success may no longer be managing the fund.
Have you ever been married or engaged or considered either? How much do you think a diamond engagement ring should cost? For many of you, the answer is “two months’ salary.” That’s the “rule of thump” most people use for answering that question, a rule promoted by the diamond industry in ad campaigns and informational material. It’s a completely ridiculous figure- a ring should cost no more than you can afford! But it has become a standard point of reference for engagement ring purchases. Diamond merchants, you see, understand that by leading people to start with a dollar figure equal to two months’ salary , they almost certainly guarantee more money for their industry. Why’s that? Because people who might have spend less for a ring will have been programmed to think that two months’ pay is the point below which they’re being a cheapskate (and what man wants his fiancée to think that?). They’ll anchor on the equivalent dollar figure if they don’t know that this is happening- or even if they do. Meanwhile people who would likely spend more than two months’ salary will do so anyway- they’ll assume that the benchmark is for people who don’t have as much money as they do or don’t love their fiancées as much.
This is another factor behind the phenomenan we discussed earlier, whereby people tend to hold on to losing investments longer than winning ones. If you buy a stock at $50 a share, that becomes your anchor when evaluating the worth of the stock down the road. In fact, it’s not even necessary for you to have bought the stock to anchor on a price. In the early 1990s the stock of U.S. Surgical Corporation increased fourfold to $131.50 in just one year. Subsequently, when the share price dropped to $56.50 in 1992, many investors thought the stock “looked cheap” compared with its all time high, and they rushed to invest.
They had anchored on that $131.50 and looked pretty smart for their trouble when the medical supply company’s shares jumped up to $76.50. Unfortunately the stock dropped to $16 in early 1994, thanks to increased competition. Mind you, it’s hard not to sympathize with those investors who anchored on the stock’s all-time high. Even if the current finances or future prospects of a company in question have changed so that its share may have justifiably dropped in value, it’s difficult to erase the original purchase price (or highest price) from memory. Pulling up anchor is harder than you might think.
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 is 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, or when you are a buyer, disregard what your aunt Clara’s neighbor paid. Do your research and be thorough.
One of the reasons people think so highly of themselves in that they often don’t recognize when they’ve been wrong. Even when events prove a decision foolish, people frequently explain it away and emerge with their confidence intact. Stockbrokers, in fact, have a joke about this tendency, which goes something like this: “When the price goes up, the client thinks he picked a great stock. When the price drops, the client knows that his broker sold him a lousy one.” People have an impressive knack for snatching subjective victory from the jaws of objective defeat. To be sure, faith in one’s judgement- believing in your ability to make decisions that are in your best interest- is a crucial element to personal progress. But too much faith and too much confidence can lead you to unwise and unproductive decisions.
Quick! How do you pronounce the capital of Kentucky: “Loo-ee-ville” or “Loo-iss-ville? Now, how much money would you bet that you know the correct answer to the question: $5, $50, $500?
Because people are sure they know the “s” in Louisville is silent (which it is), they’re confident that such knowledge is all they need to win the offered bet. In fact, what they really need is the knowledge that the capital of Kentucky is Frankfort.
If people were not overconfident, for example, significantly fewer people would ever start a new business: most entrepreneurs know the odds of success are against them, yet they try anyway. That their optimism is misplaced- that they are overconfident- is evidenced by the fact that more than two-thirds of small business fail within four years of inception. Put another way, most small-business owners believe that they have what it takes to overcome the obstacles to success, but most of them are wrong.
A major reason most individual investors underperform the benchmark investment averages over time is that most individual investors think they know more about investing than they actually do.
“A rising tide lifts all boats”- that means that even some bad stocks go up in price when the market in general is rising. We might just as easily coin another phrase- “a rising market lifts all egos”- that means that many people inflate the effect of their own decisions and underestimate how much of their recent investment performance is due simply to the fact that the U.S. economy and stock market have been on a roll and that they’re just along for the ride.
When things happen that confirm the correctness of your actions or beliefs, you attribute the events to your own high ability. Conversely, when things happen that prove your actions or beliefs to have been mistaken or wrong- headed, you attribute those disconfirming events to some other cause over which you had no control. The net result is that you emerge from a checkered history of success and failure with a robust optimism about your prospects for the future. A little better luck, or a little fine turning, and the outcome will be much better the next time.
Case in point: A fellow Gary knows invested in Applied Materials in 1996 because the company was the dominant supplier of the machines that computer makers use to make their chips. And he took full credit when the stock raged over the next year. He proudly explained that he understand better than most how ubiquitous computer chips were becoming and how changing technology required manufacturers to constantly update their equipment. His confidence in his ability to pick winners soared. On the other hand, when economic problems in Asia pulverized the share prices of all semiconductor equipment makers in 1997, his confidence in his investing acumen was not shaken. After all, how could he know that Asia’s woes would hurt Applied Materials’ profits? Well, one answer is that he might have known had he bothered to learn that 50 percent of semiconductor equipment purchases at the time originated in Asia. The better answer is that Gary’s friend, who is not in the semiconductor business, might not be the best person to evaluate the future of the companies that manufacture chip-making equipment.
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