Understanding Ourselves As Investors
It wasn't too long ago that accepted economic theory held that humans are fundamentally rational and self-serving when it comes to money. Accordingly, the assumption would be that we consistently make logical financial decisions that are in our long-term best interests. Now if you're raising an eyebrow as you read this, you do so with good reason. Otherwise, why would so many Americans stash their cash in something like a savings account or a bank CD when they're losing money every day? Why would so many of us be willing to pay more for a product bought on credit rather than in cash? Why would we continue to chase past returns instead of looking to the future? And why would we fail to take complete advantage of our tax-advantaged accounts?
To answer these and other questions, a new breed of economist has been examining the ways we really behave. Here now are just a few of the insights provided by this cross between psychology and economics - commonly referred to as behavioral economics. No doubt, most of us will see just a little bit of ourselves in these examples.
If you tend to treat your hard-earned money differently from the way you treat other money - such as tax refunds or lottery winnings - then you're guilty of what the behavioral economists call "mental accounting." This concept, developed at the University of Chicago, describes our tendency to categorize and value our money according to its source or how we spend it. This tendency can be beneficial if you are safeguarding funds for college or retirement. Mental accounting can also be dangerous though - because in reality one dollar is worth just as much as the next. One hundred dollars that you get from a windfall will buy you just as much as $100 you've saved. Likewise, if you feel much freer spending money when you use a credit card than when you pay in hard cash, you are likely practicing a form of mental accounting.
If you're the type who continues to pour money into an old jalopy, you're falling victim to what the behaviorists call the "sunk-cost fallacy." If you wouldn't want to buy the car today, knowing that it needs endless repairs, why would you want to waste money continually propping it up?
Research shows that the pain we feel from losing money is often much greater than the pleasure we experience from gaining the same amount. As an investor, this means that you may resist selling your losing investments, even if your money could be better invested elsewhere. On the other side, and just as dangerous, loss aversion can cause you to sell a successful investment too soon in order to protect your current gain.
In a fascinating study, researchers set up a jam-tasting booth in an upscale grocery store to test how the number of choices affects our ability to make decisions. Half of the time the researchers offered 24 jams for tasting. The other half of the time they offered only six. The result? Customers who had only six jams from which to choose purchased a jar 30% of the time. The customers who were able to sample 24 flavors made a purchase only 3% of the time! Of course the consequences of not making a choice are much more serious for an investor than they are for someone shopping for groceries. For example, this can translate into keeping too much of your money in a savings account. Or it may mean that you don't invest your IRA properly. The irony, of course, is that by not choosing a mutual fund or a stock - and instead keeping your money in a savings account - you're still making a decision.
If you have a tendency to tune out when faced with numbers and math, you're succumbing to what is sometimes referred to as "number numbness." Clearly, this won't work to your advantage as an investor. Ironically, most of the math you deal with as an investor is simple and straightforward. But if you fail to appreciate the power of compound growth, or avoid evaluating a mutual fund on the basis of its expense ratio just because numbers are involved, your overall portfolio return will suffer.
From the famous Tulipmania in the 1600s to the dot-com bubble in 2000, history is full of examples of how blindly following trends can work against you. Or as I like to phrase it, "Whenever you follow the herd, you always run the risk of stepping into whatever the herd leaves behind!"
Although overconfidence is not the sole domain of men, a well-known study conducted by the University of California at Davis showed that overconfidence led men to trade 45% more frequently than women and earn annual risk-adjusted net returns that are 1.4% less than those earned by women. So gentlemen, the message is very clear: Don't allow your moxie to overrule your better judgment. Do your homework, diversify your holdings carefully, and never think that you can time the market.
Discussions about money are often emotionally charged, and as the behaviorists have demonstrated, we don't always make the most logical or advantageous decisions. So the next time you're facing a major financial decision, the best advice to follow is this: First of all, slow down; do the math; then weigh your options. And if you're not careful, your gut may get the better of you.
* * * * *
To answer these and other questions, a new breed of economist has been examining the ways we really behave. Here now are just a few of the insights provided by this cross between psychology and economics - commonly referred to as behavioral economics. No doubt, most of us will see just a little bit of ourselves in these examples.
If you tend to treat your hard-earned money differently from the way you treat other money - such as tax refunds or lottery winnings - then you're guilty of what the behavioral economists call "mental accounting." This concept, developed at the University of Chicago, describes our tendency to categorize and value our money according to its source or how we spend it. This tendency can be beneficial if you are safeguarding funds for college or retirement. Mental accounting can also be dangerous though - because in reality one dollar is worth just as much as the next. One hundred dollars that you get from a windfall will buy you just as much as $100 you've saved. Likewise, if you feel much freer spending money when you use a credit card than when you pay in hard cash, you are likely practicing a form of mental accounting.
If you're the type who continues to pour money into an old jalopy, you're falling victim to what the behaviorists call the "sunk-cost fallacy." If you wouldn't want to buy the car today, knowing that it needs endless repairs, why would you want to waste money continually propping it up?
Research shows that the pain we feel from losing money is often much greater than the pleasure we experience from gaining the same amount. As an investor, this means that you may resist selling your losing investments, even if your money could be better invested elsewhere. On the other side, and just as dangerous, loss aversion can cause you to sell a successful investment too soon in order to protect your current gain.
In a fascinating study, researchers set up a jam-tasting booth in an upscale grocery store to test how the number of choices affects our ability to make decisions. Half of the time the researchers offered 24 jams for tasting. The other half of the time they offered only six. The result? Customers who had only six jams from which to choose purchased a jar 30% of the time. The customers who were able to sample 24 flavors made a purchase only 3% of the time! Of course the consequences of not making a choice are much more serious for an investor than they are for someone shopping for groceries. For example, this can translate into keeping too much of your money in a savings account. Or it may mean that you don't invest your IRA properly. The irony, of course, is that by not choosing a mutual fund or a stock - and instead keeping your money in a savings account - you're still making a decision.
If you have a tendency to tune out when faced with numbers and math, you're succumbing to what is sometimes referred to as "number numbness." Clearly, this won't work to your advantage as an investor. Ironically, most of the math you deal with as an investor is simple and straightforward. But if you fail to appreciate the power of compound growth, or avoid evaluating a mutual fund on the basis of its expense ratio just because numbers are involved, your overall portfolio return will suffer.
From the famous Tulipmania in the 1600s to the dot-com bubble in 2000, history is full of examples of how blindly following trends can work against you. Or as I like to phrase it, "Whenever you follow the herd, you always run the risk of stepping into whatever the herd leaves behind!"
Although overconfidence is not the sole domain of men, a well-known study conducted by the University of California at Davis showed that overconfidence led men to trade 45% more frequently than women and earn annual risk-adjusted net returns that are 1.4% less than those earned by women. So gentlemen, the message is very clear: Don't allow your moxie to overrule your better judgment. Do your homework, diversify your holdings carefully, and never think that you can time the market.
Discussions about money are often emotionally charged, and as the behaviorists have demonstrated, we don't always make the most logical or advantageous decisions. So the next time you're facing a major financial decision, the best advice to follow is this: First of all, slow down; do the math; then weigh your options. And if you're not careful, your gut may get the better of you.
* * * * *
posted by Bob Moser at
3:41 PM
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