Review: Why Smart People Make Big Money Mistakes

April 17, 2010

To be successful with money, it’s not enough to have a good strategy. You also need to avoid the emotional and psychological traps that snare so many investors. Gary Belsky and Thomas Gilovich examine these pitfalls in their eminently readable book on behavioural economics, Why Smart People Make Big Money Mistakes (Simon and Schuster).

The book was originally published in 1999, but it has been extensively revised and updated. Of course, human nature hasn’t changed in the years since the book first appeared. See if you recognize yourself in any of these logical fallacies and psychological pitfalls:

Mental accounting. I admit I fell prey to this one when I opened a Tax-Free Savings Account to sock away some cash. I soon realized this made little sense when I was carrying a mortgage with an interest rate higher than what I would earn from my savings. So I closed the account and made a mortgage prepayment instead. Mental accounting makes you feel like you’re saving, even when you’re actually losing money by ignoring your debt. A similar lapse in logic occurs when we are reluctant to sell stocks inherited from a parent, even if we know we could do better with a different investment.

The sunk cost fallacy. Say you want to attend a concert and plan to buy your ticket at the box office just before the show. When the big day comes, there’s a dangerous snowstorm. Would you risk the drive? Probably not, but you’d be more likely to jeopardize your safety if you’d already paid $100 for the ticket. The sunk-cost fallacy is also known as throwing good money after bad: it’s what makes us hold on to bad investments instead of cutting our losses and starting again.

The endowment effect. Let’s use the concert ticket example again. You got a free ticket to a show you’re dying to attend, and now someone offers to buy it from you. What is the smallest amount you’ll accept? Now imagine that you don’t have a ticket and consider what you’d be willing to pay for one. The endowment effect is what makes us value something more just because we own it: in experiments, most people demand at least twice as much when selling the ticket as they’d be willing to pay to buy it. If you’ve ever tried to sell your house and refused to accept that it’s worth less than you thought, you’re guilty, too.

The ego trap. This pitfall is probably the most crippling for investors, and Belsky and Gilovich say their solution is “the most controversial statement in this book.” Couch Potatoes won’t find it the least bit troubling: “Any individual who is not professionally occupied in the financial services industry (and even most who are) and who in any way tries to actively manage an investment portfolio is probably suffering from overconfidence.” Their suggestion? Buy index funds, of course.

I obviously agree with that advice—Belsky and Gilovich would say I’m guilty of confirmation bias, or the tendency to give more weight to opinions that support our current beliefs than to those that contradict them. But even if you’re already a committed Couch Potato, you’ll find this book fascinating. It’s extremely lucid and well written, with lots of anecdotes that illustrate the research. Take the authors’ lessons to heart and you’ll certainly become a better investor.

{ 4 comments… read them below or add one }

brad April 18, 2010 at 9:11 am

I’m not sure I agree with the example you provide for mental accounting (although I agree that mental accounting afflicts most people, myself included). Your example makes sense from a purely financial perspective: unless you’re the gambling type, you’re unlikely to earn more in a TFSA than you’re paying in interest on your mortgage, so it makes sense to pay down the mortgage first.

But from the standpoint of an overall personal finance strategy, the TFSA might have made sense to keep, depending on what you intended to use it for. You’re spreading your financial risk rather than socking everything into your home and your RRSP, and you’re establishing another pot of money you can dip into when the need arises. I contribute the max to my TFSA even though it only earns about 2% in interest and I’m paying 5.2% interest on my mortgage. I am fully aware that I’m losing money by doing so, but for me the TFSA is an ideal place for an emergency fund and I didn’t have one before. I want to be able to access that money quickly in case of an emergency, and I really would prefer not to tap into my RRSP or open a home equity line of credit.

I’m probably just rationalizing a poor financial decision, but it works for me. I am not a financial optimizing machine: I find it perfectly acceptable to pass up opportunities to maximize my bottom line if I will gain other benefits or convenience that have value for me.

Canadian Couch Potato April 18, 2010 at 7:21 pm

Brad: You make a good point. From a purely financial point of view, I think it makes more sense to get approved for a line of credit and only tap that for emergencies. But if you’re more comfortable having cash in reserve, that’s a perfectly reasonable decision. If you max out your TFSA with $10,000 at 2%, rather than paying down part of your mortgage at 5.2%, your “loss” is $320 a year. A pretty small price to pay if it gives you peace of mind.

In the book, Belsky and Gilovich give an example of people who have cash socked away in a savings account will carrying high-interest credit card debt. That, I would say, is a pretty dumb financial decision.

moneyxyz April 19, 2010 at 8:42 pm

sounds like an interesting book. I use my tfsa for emergencies. My tfsa earns 3% while my mortgage is 3.55%. But after watching so many suze orman shows, I feel it necessary to have a very large emergency fund. Suze advises 8 months worth.

Dd September 8, 2010 at 6:18 pm

Great post and I have to admit that I am guilty of at least 2 of these mistakes–The sunk cost fallacy, and the The ego trap :P

Now if I can just do better than index funds ;)

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