As the stock and real estate markets rock and roll our economy and disrupt our investment futures, it is time to disengage our emotional brains and step back for a moment to allow our rational brains to catch up and decide what really is the right way to respond to the turbulence of today’s market disruptions.
In The Mind of the Market I integrate hundreds of findings from the new science of behavioral economics to demonstrate how we all make money mistakes. Armed with this knowledge the hope is that we can avoid such errors in financial judgment. Here are the top ten money mistakes that we all make and how to avoid them.
- Be Willing to Admit Mistakes. Cognitive dissonance can be reduced by changing one of the two conflicting thoughts that are causing the uncomfortable tension. This is best done by carefully examining the logic and premises behind each thought and recognizing that one of them is wrong. Instead of rationalizing through self-justification that both positions are correct, or that your actions were somehow justified, be willing to change your mind. Instead of saying “mistakes were made,” admit “I was wrong.”
- Look for the Gorilla. Because of inattention blindness, if you focus too much on the details you’ll miss the obvious. Think out of the box, change perspectives. Look for new patterns, be playful, relaxed, and see the bigger picture. Be curious, ask why, examine the unexpected.
- Attend to Your Blind Spots. Because of the blind spot bias, we see the blind spots of others but we don’t see them in ourselves, including the cognitive biases presented in this chapter! There is no sure-fire prophylactic against the power of these biases, but self-awareness of your own cognitive shortcomings is the first step.
- Losses are Twice as Painful as Gains are Pleasurable. The principle of loss aversion dictates that we will fear losses twice as much as we look forward to gains, and thus we should keep this in mind when we are thinking about selling a losing stock but hesitate because we don’t want to feel the pain of a loss. On the other hand, loss aversion can cause some investors to get out during a rough-and-tumble stretch in the stock market, instead of riding it out and cashing in on those big comeback days.
- Don’t be Overconfident. Most of us, most of the time, in most things we do, especially when it comes to money, are overconfident. The fact is, playing the stock market by buying and selling individual stocks on a regular basis is little different from gambling at a casino, and the odds are just about as good that you’ll come out ahead, or at least do as well as the stock market does overall and in the long run. Studies show that even professional investors and market analysts rarely do as well as an indexed mutual fund does in the long run.
- Anchor your Investments Properly. Because of the anchoring effect we tend to place values and make decisions based on subjective, arbitrary, or no longer applicable weights that we assign to something, for example the original price you paid for your car or home.
Watch Out for the Law of Small Numbers. When you base a decision on a single event or tiny handful of examples, make sure that they are representative of the whole class or category of that thing, keeping in mind that the fewer examples you have the greater the probability that you are basing you decision on a statistical outlier, a fluke.
Watch Out for the Law of Large Numbers. Just as a single example may not represent the whole, remember that unusual events may not represent the norm. In fact, the larger the number the greater the likelihood that something weird will happen, so we should be cautious not to place too much emphasis on that particular example.
- Frame Your Money Consistently. All money is the same regardless of the source. Because of the framing fallacy that generates different mental accounts for your money, we should remind ourselves that money spends the same regardless of its source (earned, gift, bonus, refund). When you do come upon some discretionary funds (“found money”), the sooner you can sock it away somewhere out of your immediate reach, the better. If you need a little walkin’ around money, even that should be designated ahead of time, setting aside, say, five percent
- Sunk Costs are Sunk Forever. The sunk-cost fallacy causes us to consider the past in making future decisions when the past has no influence on future events. We must always recalibrate our assessments on a day-to-day basis and not stay in a losing investment, a depreciating home, a lemon of a car, a failing business, or dead-end relationship.
- Challenge Your Most Cherished Assumptions. To combat the confirmation bias, seek peer review, constructive criticism, and feedback. Self-skepticism is the antidote for all of these cognitive biases and fallacies of thinking, and we need more of it in our personal lives, in investing, in business, in the law, and especially in economics and politics. Judges should spell out to juries that the confrontational combative nature of the law that pits lawyers against one another depends on the power of confirmation bias, and especially alert them to the fact that lawyers practice it when they mine data selectively to bolster their client’s case. CEOs should assess skeptically the enthusiastic recommendations of their VPs and demand to see contradictory evidence and alternative evaluations of the same plan. Politicians need a stronger peer-review system that goes beyond the churlish opprobrium of the campaign trail. For example, I would love to see a political debate in which the candidates were required to make the opposite case — if one candidate is for gun control, the other should take five minutes to make the opponent’s case against gun control. If nothing else, it would outline the terms of the debate for the viewing audience with greater clarity.