CA 4341- Why smart people make big money mistakes

Bigness Bias

All numbers count, even if you don't like to count them. The answer is the same as the one offered for mental- be fungible.

Credit card dollars

The feel that there's seemingly no loss at the moment of purchase, at least on a visceral level, when you pay using credit card.

Weber's Law

The impact of a change in the intensity of a stimulus is proportional to the absolute level of the original stimulus.

Emotions

The reflexive system and the reflective system

Sunk cost fallacy

tendency to make a different decision depending of how much sunk (spent) money.

How to avoid confirmation bias and anchoring?

1. Broaden your personal board of advisors 2. When in doubt, check it out 3. get real 4. be maximally aware of minimum payments 5. be humble

Maximizers & satisfiers

Two types of decision makers

How to avoid herding

1. Hurry up and wait 2. Avoid hot investments 3. Do not date your investments, marry them 4. Tune out the noise 5. Rely on rules 6. Look for opportunities to be a contrarian

How to avoid mental accounting

1. Imagine a world without credit cards 2. See the tree in the forest 3. Hurry up and wait 4. Imagine all income is earned income 5. Divide and Conquer 6. Use mental accounting to your advantage

How to avoid overconfidence

1. Investor, know thyself 2. Take 25% of the top, add 25% to the bottom 3. think a la carte 4. ask three good questions

How to make wiser decisions

1. Limit the damage you can do 2. Test your threshold for loss 3.diversify 4. follow the law of five years 5. Heed the rule of 100 minus your age 6. Focus on the big picture 7. Use your pen 8. forget the past 9. press rewind 10. turn losses into gains 11. Use weber's Law to your advantage 12. Pay less attention to your investments

Some ideas to help you control your emotions

1. Voice your reason 2. Use checklists 3. Play decision chess 4. Mind your pros and cons

Examples of Mental Accounting

1. integrate losses 2. Marginal propensity to consume 3. credit card dollars 4. sacred money

How to overcome of the problems that number numbness may present?

1.Don't be impressed by short-term success 2. Because chance plays a far greater role than you thinking investment performance, you should play the averages 3. Know when time is on your side and when it isn't 4. Embrace the base rate 5. Read the fine prints

you can know too much

A yearly review of your portfolio is frequent enough.

Real Hourly wage

Annual Earnings - Annual costs (divided by) Hours spent on Work- Related tasks

Small tweaks can have big results

Assumptions should be positive, rather than the negative. Opt out a participating rather than opt in to participating.

Mental Accounting

Leads you to treat college savings or an emergency fund as sacred. Ideally we should view all money as the same. (Park "found" money in a savings account or investment account until you decide what to do with it.

Bigness Bias...

Tendency to be indifferent about small numbers, although it can cost big bucks

Probability Illiteracy

Tendency to fail to understand the role of odds and chance

Money Illusion

Tendency to ignore inflation

Satisfiers

looking for a good enough solution, make choices through combination of the best available information, gut instinct, and the advice from a trusted screener

Loss aversion

Basic concepts of the inconsistent way people treat losses and gains: (Tendency to take more risk if it means avoiding a sure loss, tendency to be more conservative (less risk) when given the chance to lock in a sure gain)

Trade off contrast

Choices are enhances or hindered by the the trade-offs between options, even options we would not choose anyway.

How to avoid choice conflict

Choose fewer choices Remember: deciding not to decide is a decision Don't forget opportunity cost Put yourself on autopilot Make deadlines work for you Play your own devil's advocate If you are not an expert, ask one

Fungible

Every financial decision should result from a rational calculation of its effect on ourother all wealth. Intellectually difficult and emotionally taxing, to calculate the cost of every short-term transaction (to deal with this daunting task we create mental accounts) ($100 won at roulette table, $100 earned, $100 from grandma)

Hindsight Bias

People conveniently remember their successes but repress or forget their failures.

Confirmation Bias

It's hard to prove yourself wrong. Enlist the help of a "trusted scanner". Tendency to search for, treat kindly, and be overly impressed by information that confirms your initial impressions or preferences. Once you develop a feeling about a subject - no matter how unconscious that preference might be- it becomes hard to overcome your bias- first impressions are very important.

Prospect Theory

Losses hurt you more than gains please you. Saving money through payroll deduction is experienced as a foregoing gain (passing up the bigger check) rather than an outright loss (paying into savings "out of pocket").

Decision Paralysis

Makes the idea of many proactive decisions daunting and uncomfortable

Three regular issues with humans and numbers

Money illusion, probability illiteracy, bigness bias

Sunk Cost Fallacy

Money that's spent is money that doesn't matter. (The past is the past, what is important is what is likely to happen next) (What if you keep going to the gym and working out because the membership cost you so much and you paid for a year long membership) Its all in how you look at it. (Rejection vs. selection or protecting gains vs. avoiding losses. Go with the positive "selection" and "gains".

Extremeness Aversion

People are more likely yo choose an option if it is an intermediate choice within a group, rather than at one extreme end.

Status Quo Bias

People are naturally disposed to favor the familiar and keep things much as they have been.

The ego trap

People tend to invest something that they are familiar with. But something familiar (e.g. toothbrush you use, donuts you buy, car you owned) does not always mean that it is a sound investment. People confuse familiarity with knowledge.

Endowment Effect

People tend to overvalue what belongs to them relative to the value they would place on the same possession or circumstance if it belonged to someone else.

Regret aversion

People want to avoid the pain of regret and the responsibility for negative outcomes

reflexive system

Reaction as soon as something happens (when something good/bad happens) (when you get a new car and go show it off)

Conformity

Result from uncertainty, we follow others because we don't know what to do, allowing the judgment of others to steer you into unwise investments, or out of sound ones. We often feel that by doing what everyone else does is not a bad thing.

Head I win, Tail It's Chance

The idea is that when things happen that confirm the correctness of your actions, you attribute the events to your own high ability, Conversely, when things happen that prove your actions to have been mistaken, you attribute those discomforting events to some other cause which you had no control.

Sacred Money

The tendency to mentally account for money as so sacred we become to conservative with it.

Mental Accounting (cont.)

The tendency to value some dollars less than others and thus waste them. The inclination to categorize and handle money differently depending on.....(where it comes from, where it is kept, and how to spend it) (storage, purpose, source)

Herding

The trend isn't always your friend. (Know they self!)

Prospect theory

The way we frame decisions, the ways we label outcomes.and how they affect our attitude toward taking risks. An attempt to incorporate psychological principles (such as Weber's Law) to explain why people choose the way they do

Marginal Propensity to Consume

To spend more because you just got some extra money. You get a tax refund and it makes you spend more because you feel that you have extra money.

Decision Paralysis

Too much choice makes choosing tough. Enlist the help of a "trusted scanner" to pare down chooses. (Use Consumer Reports)

Maximizers

Want to know everything about a choice; spend a lot of time, effort, and emotion researching options, hope to make the best choice possible

Integrate Losses

When we incur a loss or an expense, we prefer to hide it from ourselves within a bigger losses or expenses

You may be prone to the anchoring or confirmation bias if...

You are confident about your ability to negotiate and bargain, You make spending and investing decisions without much research You are especially loyal to certain brand without reasons, you find it hard to sell investments for less than you paid, you rely on sellers to set a price rather than assessing the value yourself

Warning signs of Mental Accounting (You may be prone to mental accounting if..)

You do not think you are a reckless spender but you have trouble saving, You have savings in the bank and revolving balances on your credit cards, You are more likely to splurge with a tax refund than with savings. You seem to spend more when you use credit cards than when you use cash, Your retirement savings are in fixed-income or other conservative investments

Warning signs of decision paralysis...

You have a hard time choosing among investment options, you do not contribute to retirement plans at work, you tend to beat yourself up when your decisions turn out poorly, you frequently buy things that offer trial periods but infrequently take advantage and return them, you delay making investment or spending decisions.

Number Numbness warning signs

You invest in last year's hot mutual funds, You have very low insurance deductibles, You don't really understand the relationship between inflation and buying powers You invest without much concern about commission costs and management fees, You ignore the implications of compound interest and let your credit card balances carry over, You don't really understand compound interest

You might be a victim of loss aversion or the sunk cost fallacy if...

You make important spending decisions based on how much you have already spent, you generally prefer bonds over stocks, you tend to sell winning investments more readily than the losing ones, you are seriously tempted to take money out of the stock market when prices fall

you may be prone to following the herd if..

You make investment decisions, You invest in "hot" stocks or other popular investments. You sell investments b/c they are suddenly out of favor, not because your opinion of them has changed. You are likely yo buy when stock prices are rising and sell when they are falling. You make spending and investment decisions based solely on the opinions of friends, colleagues, or financial advisors, Your spending decisions are heavily influenced by which products, restaurants, or vacation spots are "in".

Overconfidence may cost you money if...

You make large spending decisions without much research, you take heart from winning investments but explain away poor ones, you think you are "beating the market" consistently, you make frequent trades, you favor package deals and annual memberships over a la carte pricing, you do not know the rate of return of your investments, you believe that investing in what you know is a guarantee of success.

Anchoring

You pay too much attention to things that matter too little. (Ask "Is your anchor true?") Clinging to a fact or figure or an idea that may or may not have any real relevance to your judgments or decisions (Tendency of latching onto an idea or fact and using it as a reference point for future decisions)

Reflective system

You reflect on it & slow down & go over the numbers

You may be prone to reflexive financial thinking if...

You spend money in impulsive bursts, you shop when you are feeling blue, you tend to buy extended warranties or extra insurance policies, just to be safe, You feel ultra anxious when stock prices fall, even if you do not need your invested money for years to come, you tend to hold on to wining investments well beyond the price you think the security is worth, You routinely spend more for goods and services than you planned to

Follow a process or plan

You're not good at predicting the future

Overconfidence

Your confidence is often misplaced. (Keep yourself humble by reviewing past mistakes) (People are probably not as smart as they think they are.)

Wait a year

Your emotions affect your decisions in more ways than you imagine