Have you ever made a big gain in a stock and then seen your gains evaporate because
you held on to it too long? Have you ever stayed with a loser until it was worth virtually
nothing? Or maybe you couldn’t part with a stock you inherited from your dad that made
up a substantial portion of your total investment portfolio and then saw it rapidly drop in
value. People often hold on to a stock with big gains because they don’t want to pay the
capital gains tax and then lose 20% to 30% when the stock tanks for any of a number of
reasons.
We have a lot of psychological hang-ups that impact not only our investment portfolios
but many other areas of our financial well being. A new scientific study called behavioral
economics looks at how investors think, the mistakes they make and how they can
benefit from understanding those mistakes. The book titled Why Smart People Make
Big Money Mistakes – and How to Correct Them: Lessons from the New Science of
Behavioral Economics by Gary Belsky and Thomas Gilovich (Simon & Schuster) is a
very easy read that’s difficult to put down.
Behavioral economics attempts to understand the links between psychology and
economics. By doing so, people can potentially enhance their enjoyment of life by
understanding, and changing the way they make money decisions.
One example discussed in the book is the concept of “mental accounting”. The book
presents two scenarios:
“Imagine that you’re at the racetrack for a day of gambling or at your favorite store
shopping for a suit. Yesterday you won $ 1000 from your state’s instant lottery game.
Will you bet more tonight than you would otherwise, or will you buy a more expensive
suit?”
“Now imagine that you’re once again at the racetrack for a day of gambling or at your
favorite store shopping for a suit. Yesterday you realized that you had $1,000 in a
savings account that you had forgotten about. Will you bet more tonight than you would
otherwise, or will you buy a more expensive suit?
The authors point out that “if you answered yes to the first question and no to the
second –-- as most people would--- you’re prone to mental accounting.” Mental
accounting involves putting different values on the same dollars just because they came
from a different source. Why should lottery winnings be valued any differently than your
hard-earned salary or savings? Nearly all of us do this.
Another of the basic principles of behavioral science discussed in the book is that
people are “loss averse”. According to the authors- “the pain people feel from losing
$100 is much greater than the pleasure they receive from gaining the same amount.
This helps to explain why people behave inconsistently when taking risks. For example,
the same person can act conservatively when protecting gains (by selling successful
investments to guarantee profits) but recklessly when seeking to avoid losses (by
holding on to losing investments in the hope that they’ll become profitable.)”
There are a number of psychological obstacles that keep us from acting in our best
interest, financially. Just being aware of them can help. We highly recommend that
everyone read Belsky and Gilovich’s book. If you don’t have the time, below are a few of
the steps they recommend to improve your financial well-being:
(1) Raise your insurance deductibles to $ 500 or even $ 1000. You may be able to cut
premiums by 10% or more.
(2) Pay off credit card debt with emergency funds. It makes sense to pay off 16% credit
card debt with funds earning perhaps only 3% to 5% in a savings account.
(3) Switch to index funds in your investment portfolio. It’s very tough to beat the market.
Mutual fund expenses and taxes eat away at your returns. Index funds are low-cost and
tax efficient.
(4) Diversify your investments. Holding a diversified portfolio will reduce the volatility in
your returns and help you avoid over-reacting to the market’s gyrations.
(5) Track your spending Understanding where your money is going will help you feel
more in control of your finances and better understand the behavioral-economic factors
that affect how you manage your money.
In summary, understanding a bit about behavioral economics can have a significant
impact on your financial well-being.
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, October, 2007
Bad Behavior Can Cost You!
By David and Erin Patterson