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How to Avoid Money Mistakes

by Michael Shermer, Dec 02 2008

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.

  1. 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.”
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.
  7. 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.

  8. 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
  9. 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.
  10. 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.
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11 Responses to “How to Avoid Money Mistakes”

  1. hehe Look for the Gorilla! I love that experiment! (i.e. http://viscog.beckman.uiuc.edu/grafs/demos/15.html )

    As to the list, if you think about it, that’s a pretty darn good list for ANYTHING we think about (modified out of financials into something more generic of course). Good blog entry, and I always enjoy reading what you have to say.

  2. Ian Mason says:

    Of course it would be out of the question for an American to be skeptical about capitalism itself. Our present economic and political systems function according to unchangable natural laws.
    Try reading Bertrand Russell’s intro to his “Skeptical Essays”.

  3. Max says:

    How does Shermer reconcile his Libertarian stance with the fact that people are irrational and make all these money mistakes? Does he argue that bureaucrats are not much more rational?

  4. Andy says:

    Nitpick: The “law of large numbers” does not mean what you said it means.

    Max: If people can’t even manage their own money, why do we trust them to manage other people’s money (i.e., why do we trust the government to manage our taxes)?

  5. Max says:

    Andy, speaking of the law of large numbers, the government can make those who can manage their money (or are just lucky) bail out those who can’t (or are unlucky).
    Also, perhaps it’s easier to be rational with other people’s money and without the profit motive. Probably not, but I’d like to see what the studies say.

  6. Max says:

    On the one hand, loss aversion makes us wait too long for a rebound that doesn’t happen. On the other hand, loss aversion makes us wait not long enough for a rebound that does happen. The only question is how to know whether or not a rebound will happen. Fortune telling?

  7. oldebabe says:

    Not only good as advice about individual money management, but also excellent reference guidelines for day-to-day ‘choices’ in general…

  8. The Blind Watchmaker says:

    Any learned skeptics’ thoughts on Harry Dent’s demographic spending wave hypothesis?

  9. ubermensch says:

    Ian,

    OK, so let’s try being skeptical of capitalism. So what?! What’s the alternative? Perhaps I’m grossly mistaken, but what alternative comes even close to providing the level of per capita wealth, etc. of the market? Besides, maybe I’ve blinked, but where, on earth, has unfettered capitalism EVER occurred?!

    I’m skeptical of those who are skeptical of capitalism.

  10. Well, I came here because Bob Carroll was touting Shermer. I’ll tell you the same thing I told him, Michael:

    Smith’s “invisible hand” came directly from the metaphysical pages of Deism and is totally unscientific. Shermer knows better that there is neither an “invisible hand” nor a “free market.”

    I do hope Bob and SD aren’t back to the days of Penn and Teller’s quondam pseudoskepticism.

    ===

    And, Ubermensch, I’m skeptical of those who are skeptical of those who are skeptical of capitalism.

    ===

    Max — Shermer probably does it with smoke and mirrors, and by basically ignoring behavioral psychology and behavioral economics.

    ===

    And, in at least one of his books, which I reviewed on Amazon, Shermer partially repeated an urban legend about the origin of the typewriter keys’ layout.

  11. Lovely blog! Thanks for the useful information.