Posts Tagged ‘investing’

Why Smart People Make Big Money Mistakes – And How to Correct Them: Lessons From The New Science Of Behavioral Economics is a book with an obserdly long title. It’s written by Gary Belsky and Thomas Gilovich.

I first assumed that it was going to be about why professional investors do stupid things. I was incorrect, much to my advantage. It was about us, all of us. We are the smart people making the big money mistakes.

A lot of the content I already knew from reading A Random Walk and Thinking, Fast and Slow, but it was all a valuable reminder. Especially as I am still making many of the mistakes! Though as the book concludes, as fallible humans we are probably going to continually make them. It’s a fun book to read as you get scenarios and have to try and guess the right answer. Just like QI, you quickly learn to avoid the obvious answers.

Mental accounting is a classic example. A pound is a pound. Yet so often we sub-divide our money into different funds that are more or less valuable. I was in this exact scenario as I was reading it.

I had recently received some compensation for a car accident. I was thinking about buying a stand mixer with it. It’s bonus money, right? At the end of each month, I do a spreadsheet of all my bank balances and debts to see how much money I had on. In this case, I had even put a debit in to cancel out the effects of the extra money in my bank account, so that I could keep that money in a separate mental account.

But this is nonsense! I have that money, and it is just as valuable as any other money. If I can justify buying a stand mixer, I can justify it from my savings as much as from ‘found’ money as it is often called. If I can’t, then I shouldn’t be buying it. So I took the advice from the book – I removed the entry on my spreadsheet and I sent the money to my savings account. If I can justify taking it out, I can buy the stand mixer. If not, the money stays in my savings. Either way, all money has the same value.

The best way to avoid this issue is to put found money into your savings account, count it as part of your total savings for a while, then see if you still want to make the purchase.

Another example I fall pray to is using big purchases to hide additional extras. When I was going to buy my first desktop computer, I thought about buying a tablet to go with it. In the shadow of the cost of the computer, it wasn’t that much money. Luckily, my dad talked me out of it. I could have bought one later, but I never did because I could not really justify the cost on its own.

Contrast this with when I bought a piano. They offered to sell me a stool with it. It was a small cost in compassion to buying a piano. But did I really need it? I decided the sensible thing to do was wait and see if I really needed it, and could justify the purchase on its own. Six months later and I am still just using a dining chair, and it works fine. Better even, because a stool would get in the way.

Sunk cost fallacy is the idea that once you have spent the money it is gone, but people do not often actually believe this. The classic example is paying for a cinema ticket, or entry to a nightclub, getting bored, and then staying anyway to “get your money’s worth”. Of course, in reality, the money is gone and you are just wasting another valuable commodity, your time, by staying there bored.

This in itself doesn’t cost you money of course. However, other examples do. Take, for example, selling a house. People will often refuse to sell a house for more than they bought it for. Why? The buying price is irrelevant. If you need to sell your house, you should do so for the highest price you can get, rather than holding on to it because of an irrational psychological anchor. Yet, we’re all human, and I am sure I would try and hang on too, even though the rational part of my brain would be calling myself an idiot.

The book also talks about the ideal number of choices. Quoting the famous jam study. If you give people six choices, they are more likely to buy than if you give them 24. I mentioned this a few days ago in my review of the Happiness Hypothesis. It is worth noting that six and 24 were just the values that were picked for the experiment: it does not conclude that exactly six choices is the optimal number.

Insurance is an area that I am getting better at. I never took out extended warrenties and phone insurance anyway, but Daniel Kahneman has long since convinced me that I am correct not to do so. Insurance is a money making product, so if you could afford to replace it, you should not have insurance. I would be very annoyed if I smashed my £600 iPhone tomorrow and had to buy a new one. However, I could buy a new one, and the money I have saved over the past decade of owning a phone, not paying for insurance, and not smashing it, would still leave me in heavy profit.

A sneakier example is insurance excess though. On top of the £150 mandatory excess on my car insurance policy, I have an optional £250. Sometimes I think I should get rid of this. However, as the book points out, that would be a bad move. I can afford the £400 excess I would have to pay if my car was in an accident, so it makes sense to take advantage of the reduction in premiums because most years I will not claim on my insurance. In my case, this is pretty academic anyway, as my insurance company doesn’t think my car is worth anything.

In short, this is a very useful book. It references a lot of Kahneman and Tversky, which is useful for the everyday money mistakes we make. It also talks a lot about retirement planning and stock market investing, which is less relevant to some people, but still useful to most.

Sebastian Mallaby’s book, More Money Than God: Hedge Funds and the Making of the New Elite, looks at the birth and rise of the hedge funds. Perhaps more interestingly, it seeks to answer the question of how those funds made money if you subscribe to efficient market theory (which you should).

A. W. Jones, the original hedge fund (or “hedged” as he called it) could explain it’s profits by an inefficient market. Before Jones, the concept of a hedge fund did not exist and he and his team began doing things that nobody else was doing. They were simply more efficient.

In the late 1960s and 1970s, Steinhardt, Fine, Berkowitz & Co. were the biggest players. This could be explained by two factors. First, they could have simply been lucky. By the time they came along there were 200 hedge funds, so the chance of one of them consistently beating the market was fairly high. Secondly, there was what you could argue was insider trading. Perhaps not to an illegal level, and it is unfair to level this claim just at hedge funds, however, it was clearly going on.

Over the next few decades, hedge funds continued to generate money. Can this be reconciled with efficient market theory? Yes and no. A lot of the profits came from exploiting loopholes and finding inefficiencies in the market. The fact that this was possible shows that markets are not always efficient.

However, if you take Malkiel’s argument that this might be there, but is just not useful, that view holds. Firstly, you have to keep exploiting new ideas because pretty soon everyone else copies you. Secondly, for an investor, there is no way to know in advance who will find the inefficiencies. It is easy to work out which hedge funds found them after the fact, but picking them in advance could well be impossible.

Also, while some funds do have amazing performance, most are not. In a 2006 paper, “The A,B,Cs of Hedge Funds: Alphas, Betas, and Costs” Roger Ibbotson and Peng Chen calculated that after adjusting for biases, the average return was 9%.

The book’s conclusion is generally agreeable. Index funds represent the best way forward for consumers, but hedge funds maybe represent good value for institutional investors.

Two of the books I have read recently, Everything Is Obvious and The Signal and the Noise, made references to Burton Malkiel’s book “A Random Walk Down Wall Street”. They pointed out that the stock market is entirely unpredictable and therefore investment bankers are just guessing. I was curious to read more, so I picked up the book itself.

An index tracks stock market movements. For example the FTSE 100 tracks 100 companies on the London Stock Exchange, while the Standard & Poors (S&P) 500 or Russell 3000 track a far more broad range of stock prices. These therefore provide a good indication of whether the stock market moves up or down.

Now take a mutual fund – these are professionally managed funds that the general public put their money in for someone to manage on their behalf. The benchmark here is not whether they can grow their investment, but whether they can grow their investment at a better rate than the index (because the stock market generally moves up anyway). If they were just guessing, you would expect 50% of mutual funds to beat the index, and the other 50% to fail, in both cases just due to chance.

However, the research, as discussed at length in A Random Walk Down Wall Street, shows that only 40% of mutual funds can beat the index! This is not just guessing – this is worse than guessing. Professional investment managers not only do not add any value to the funds they are managing, they actually subtract value.

You could make the case that there are just a lot of bad fund managers. However, the research refutes this too. As Malkiel describes, if you take the top performing funds over a five year period they almost invariably fail to beat the index over the next five year period.

This should not actually be that surprising. The Wall Street Journal has long shown that throwing darts at the stock listings produces a better return than the experts; a noticeably better return once you adjust for risk. To see it in practice (I include this as an anecdote to make the facts more believable) just watch the BBC documentary Million Dollar Traders in which eight complete notices only lose 2.5% in a period where their multi-millionaire master-of-trading coach loses 5%.

Of course it is hard to believe. Why are all these people employed if they add no value? That is a fact I find hard to reconcile. Surely if we are talking about efficient markets, at least one bank would have realised they could fire all these traders and replace them with monkeys? Counter arguments to this suggest that the average trader actually earns a pittance, and that because it is in the interest of traders (justifying their own job) and brokers (getting rich of the transaction fees from all this needless trainers) to maintain the illusion that they actually do something, the industry keeps selling these products to the general public who simply don’t realise.

The evidence, at least if Malkiel is to be believed, is clear. You should invest all your money in an index tracker with the lowest fee you can find. That produces the most consistent returns compared with a mutual fund that charges you higher fees to produce a lower return. Nate Silver says the same thing.

In the final part of the book, Malkiel goes on offer some investment advice for those who do not want to use an index fund. He also hints that he picks individual stocks too. This is odd as it goes against a lot of what the evidence he has presented says, but is consistent with what the psychology says – that we have a really hard time accepting what the scientific evidence says when it contradicts our own pet theories, achievements and so called “common sense”.