Economically-minded behaviors, Part 2

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.

Economically-minded behaviors, Part 1

I’ve mentioned before that personal finance is more about a person’s behaviors than it is a function of their ability with crunching numbers. Taking this to its logical conclusion, a corollary would become that emotions and poor judgment lead a lot of people, exceptionally bright or not, to make, simply put, dumb financial moves. Historically, psychology has played an integral role in economics. For example, when Adam Smith wrote The Theory of Moral Sentiments it included “the ethical, philosophical, psychological and methodological underpinnings to Smith's later works, including The Wealth of Nations (1776), A Treatise on Public Opulence (1764) (first published in 1937), Essays on Philosophical Subjects (1795), and Lectures on Justice, Police, Revenue, and Arms (1763) (first published in 1896).”

Hersh Shefrin, in his 2002 work “Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing,” listed three main themes for behavioral economics:

· Heuristics: Using “rules of thumb” that are, at best, approximated, instead of strict rational analyses, people tend to make bad decisions.

· Framing: The context of the problem or the way it is presented to the decision maker will often affect his or her action; which can result in a bad decision.

· Market inefficiencies: Examples such as mis-pricings, return anomalies, and non-rational decision-making can explained observed market outcomes that are contrary to otherwise rational expectations of market dynamics.

College macroeconomics courses teach a concept of “utility,” a fundamental concept in neoclassical economics which depicts perceived value in a good or service. Prospect theory, as part of behavioral economics, describes decision processes as consisting of two stages: Editing and evaluation. Editing consists of possible outcomes of the decision are ordered following some heuristic. Specifically, people decide which outcomes they see as basically identical, setting a reference point and consider lower outcomes as losses and larger as gains. In the evaluation phase, people behave as if they would compute a value, or utility, based on the potential outcomes and their respective probabilities, and then choose the alternative having a higher utility.

Keep in mind, however, while all this theory is good for a foundation of understanding the basis for the mistakes—and successes—we will inevitably have when it comes to our finances, note that these models can fail to predict outcomes in real world contexts for one reason or another. As in the science of profiling, establishing patterns and trends are keys in determining if a particular model will accurately predict a desired outcome. On the other side of the token, it is argued that while behavioral insights can be used to update economic and financial theories that we’ve come to rely upon, they also offer greater depth into these two disciplines: Not only reaching the same (correct) predictions as traditional models, but also correctly predicting outcomes where traditional models have failed in the past.

Dollars and Sense

Financial success does not happen overnight; money is not something to be had instantly. Rather, financial success is the manifestation of a specific behavior set.

Once upon a time there was a boy born in the Midwest; for the purposes of this story, we’ll simply call him W. A bookworm with a natural ability in math, he went to work at his father’s brokerage in 1941. During his first year working there, W purchased a couple shares of stock, just for kicks. Purchasing them for a bit more than $38, he sold them for $40, not making much money from them: The Cities Services stock would soar to $200 months later. In 1944, at the age of 14, he started installing pinball machines in barber shops. Earning $1,400 from the deal, he purchased 40 acres of land and rented it to tenant farmers. A good student, his love of being an entrepreneur came before his desire to attend college. By the time he graduated high school at the age of 16, he had done so in the top 20 of his class and had saved nearly $5,000. His father coaxed him into attending university; yielding to his advice and matriculating at the Wharton School for three years and transferring in the last year. In 1951 he would earn his Masters degree in Economics. By 1956, he founded his first investment partnership with $100 out of his own pocket (and several thousand from multiple limited partners, family and friends). Spending much time learning, from multiple sources, the art of investing, he would run his investment partnership from his bedroom making an excess of 30% compounded returns in a market (1956 to 1969) when 7%-11% is the norm.

In 1962 W would start purchasing shares of a failing textile company, leaving his partnerships to operate it full-time in 1969. Turning it into a holding company, he began purchasing other companies with an emphasis in insurance concerns due to their large cash reserves that they must keep. Over the years, W fashioned himself a “capital allocator,” putting significant sums of money into high-value companies and keeping existing management.

How does such a man perceive his wealth?

“I don't have a problem with guilt about money. The way I see it is that my money represents an enormous number of claim checks on society. It's like I have these little pieces of paper that I can turn into consumption. If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And the GNP would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching, or nursing. I don't do that though. I don't use very many of those claim checks. There's nothing material I want very much. And I'm going to give virtually all of those claim checks to charity when my wife and I die.”

The man? Warren E. Buffet, worth $52.4 billion as of 2007.

What can his rise to power tell the rest of us in the rise to ours?

1. Wealth-building decisions are long-term ones. Studies have shown that wealthy people made decisions for the long-term; usually doing a cost-benefit analysis for a 20-year period. Those on the opposite end of the wealth spectrum, on the other hand, make decisions for the short-term, “what will make me happy now?” In fact, you are more apt to make your own million than to inherit it from someone else: 86 percent of millionaires are first generation; the money is not inherited. Your wealth is the sum total of your decisions to date.

2. Wealth relates more to behaviors and less to number crunching. Think that there is something special about the affluent, like getting an inheritance or maybe that you have “bad luck” over other people? Research has found that wealth disparity couldn’t be explained by income—differences by income only accounted for a 5 percent dispersion. Furthermore the researchers noticed that “’chance events’—inheritances, medical bills, marital status, number of children— explained about 4% of the dispersion.”

3. Don’t spend more than you earn. This is a simple axiom: If your net income is negative over a long enough period of time, no matter what your financial goals are, you will not be able to achieve them.

4. Pay off debts. The less debts you have, the more your cash flow will increase. Your income is the most powerful wealth-building tool that you have, and the less strain it has to provide for you, the more ability you will have to become financially successful.

5. Have a clear plan laid out—financial and otherwise. Dream big, but fashion it with rationality. If you plan to be a millionaire in 5 years and you’re currently making $30,000 per year…something drastic will need to happen to get to where you want to be.

6. Find opportunities and learn how exploit them. Success is when opportunity meets preparation. This means everything from being able to spot something that could be profitable in the stock market to knowing when to make a move at your job that could be advantageous to you.

7. Persevere. History is riddled with stories of the greats that kept on doing something “just a bit longer” than everyone else. Their determination and purpose to achieve their desired result allowed them to achieve their goal, which often led to financial success of some fashion.

8. Invest in yourself. If your income is your most valuable wealth-building tool, you are the reason that your income is such a valuable tool. Investing in yourself means sharpening and expanding your skill set through self-directed study and formal education. It also means doing those things to enhance the positive aspects of your life and minimize—or get rid of—the negatives.

9. Help others achieve. Success begets success. Helping others achieve not only helps them, it also helps you: Mentoring offers a different perspective that many people don’t realize and, therefore, don’t care to tap into. Humans are a creature that relies on community; we each have a symbiotic relationship with one another in the sense that what comes around goes around. Just s your success relies on the choices of other people; the success of other people will rely on the choices which you make.

10. Become an entrepreneur. Take an attorney, for example: With about 10 years experience, they have a median salary of about $100,000; considering a conservative 2,000 billable hours each year (for about 2,800 hours worked) at $250 per hour that the client is being charged, you are only realizing 20 percent of the business you are bringing into your law firm. All “blue sky value” aside, you could still make more doing that—albeit with more work—than the alternative of working for someone else. In the greater scheme of things where the affluent are separated from the economically (behaviorally) disadvantaged, having employees that earn you money is what sets the financially successful apart from the rest.

Lastly, think of earning money in this fashion: Split the day into 24 hours and divide your daily earnings by 24. How much money are you making per hour? If you’re working at McDonalds, chances are that you are making, what, about $3 per hour? If you’re the lawyer above, you’re earning significantly more than that. Determine ways to be creative and raise that “hourly earnings” rate that you have.

Money is almost entirely about the decisions that we make from day to day about tomorrow. To repeat something I mentioned earlier: Your wealth is the sum total of your decisions to date.