Why Smart People Make Big Money Mistakes
Tuesday, January 5th, 2016 | Books
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.
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.
