Smart Money magazine recently ran an article with the tagline “Emotions and poor judgment lead a lot of smart people to make dumb financial moves.” Given my interests in psychology and economics, I thought this a perfect opportunity to review a few insights about money and behavior through the scope of this article.
1. “Saving with the right hand, spending with the left.” Are you one of those people who fixate on the price of a new automobile, but don’t monitor your routine shopping habits, such as groceries and entertainment? Do you think that it is a rational—or even acceptable—decision to have a savings account with a 5 percent rate of return, while you still pay much more than that for your credit card interest rate? How about the IRS: Do you set your tax withholdings in a given year so that you receive a high return at the end of the year?
The article duly points out a few more logical methods for dealing with the above scenarios. For instance, the average credit card debt of an American is about $1800; an amount that most households have in savings to pay off. Paying it off increases the rate of return on the money remaining in savings by reducing the strain placed on it from other parts of your cash flows. How about the tax withholding situation? Why don’t you instead set it more accordingly—so the IRS does not get so much of your earnings—and you invest it in an account that earns you money throughout the year; instead of offering the government an interest-free loan, you can make that money work for you. Controlling your financial present and future is a lot about making every dollar “scream:” That is, the harder you make your money work for you, and the less you use it to consume now, the more you will have to consume later. Radio talk show host Dave Ramsey has a saying that he fondly recites on his radio program: “Today, live like no one else, so later, you can live like no one else.”
2. And 5…“Playing it too safe,” and “Throwing good money after bad.” People don’t like losing. As I’ve mentioned before, “people are more displeased by a loss than they are over a comparable gain: In America, at least, we typically need to offset an unexpected loss by a gain of 2.5 times that loss.” This loss aversion, obviously, extends to money. An example cited in the article is of the classic fuel-purchasing “penny pincher:” Driving miles out of their way to save as many cents per gallon when, in fact, the fuel consumption and the wear and tear on the person’s vehicle will cost about 6 times the amount that the person is saving. Individual investors, also, have the same attitude towards averting loss whereas they will be more apt to sell a winning stock than a losing one. The “sunk cost” bias tells us that we tend to feel that we’ve passed the “point of no return” and feel that cutting one’s losses would be a waste of resources—time, money, and otherwise. In fact, decisions about future investments should be made based on future possibilities and not biased by recent investments within the scope of the current scenario.
3. “Looking into a cloudy crystal ball.” While more than two thirds of Americans have life insurance, those in the 35 to 64 years old age bracket are six times more likely to be injured to such a degree that they would miss an extended amount of work—than they are to die. The upshot? Less than one third of us have disability coverage. People base their prediction of the frequency of an event or the proportion within a population based on how easily an example can be brought to mind—in other words, we tend to take “short cuts” to the conclusion that we want to draw with the information that is available to us, relying easily on images and experiences that come to mind more quickly than more logical alternatives. The article duly points out, via the words of University of Chicago researcher Cass Sunstein, a phenomenon known as “probability neglect:” “We tend to ask what’s the worst—or best—that could happen. Instead, we should be asking what’s likely to happen.”
4. “Living in the moment.” People like to procrastinate. Watching your favorite television program (or any television program at all, for that matter) instead of cleaning the garage or the attic is often more appealing and offers a more immediate reward than the alternatives. Instead of looking at the non-linear benefit or the delayed costs and rewards, people tend to look at the immediacy of them instead.
“Letting your ego get in the way.” Overconfident investors tend to have good experience and think they are skilled, while in reality luck may play a larger factor than skill. Because it is easiest to think about, focus, and analyze ourselves and our ability we will tend to take a shortcut back to ourselves and our own abilities and skills. Confidence is good; and a healthy dose of overconfidence (despite the definition and connotations otherwise) is good: Without it, we wouldn’t have a propensity to strive for what’s better, what’s next. An unhealthy amount of confidence when dealing with the stock market, it is pointed out in the article, trend towards high risk investments, overtrading, and under-diversification, and, ultimately, smaller rewards over the long term. Investing for all but the die-hard day trader, is like making a burger in that you get the fundamental essence of what you want and continue to play with it less, only moving it such that it doesn’t get burned, taking it off the grill when it’s ready to eat.
7. “Following the crowd.” Just because everyone else is doing it means that you should, too, 
right? The Bandwagon effect, or following the herd, is essentially the observation that people often do or believe things because many other people do or believe the same. Funny enough, a Yale study entitled “Dumb Money” by researchers Owen Lamont and Andrea Frazzini pointed out that poor sentiment was actually indicative of good future returns in both stocks and funds: Those who bought and held S&P 500 index after Black Monday have made eight times their investment; on the other side of the coin the more popular investments have been shown to underperform. The company that developed the ever-popular iPod and iPhone, Apple, has skyrocketed in the last year or so: Stock that I started monitoring at $117.98 is now worth 106.88 percent more than the price I began monitoring at. Some industry experts, however, have predicted that after the buzz of the iPhone wears off, the stock may finally start to deflate—if not plummet. Time will tell if these predictions are correct, however.
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