The Amateur Financier

By this point in our little exploration of your inner mind, you might be getting a little upset.  After all, we’ve seen that you (or at least, your unconscious mind) base decisions on money that’s already gone, overestimate how quickly statistical deviations will be corrected, and over-discount future money; with all of that to contend with, how much more can your brain possibly mess up your financial plans?  Well…

Disposition Effect

You know that relative who saves just about everything, keeping not only the normal mementos of friends and family (things like old report cards and artwork from children), but hangs on to everything, no matter how useless it seems to everyone else?  That’s the disposition effect at work; the nature of people to hold onto something rather selling and acknowledging how little it is actually worth. Regardless of how likely it is that we will ever use a particular item again, our minds are more at ease if we hold onto it forever, just in case.

A sunny disposition is helpful, but completely unrelated to the disposition effect

It’s the same with investments; people have a tendency to hold onto investments that have fallen in price, regardless of how unlikely it is that they will ever recover in value, rather than selling and acknowledging the loss.  Of course, the inverse is true, and can be just as damaging: we’re more eager to sell when our investments are up, regardless of how much further up they might go.  Combine the two effects, and you have the recipe for sub-par investment results regardless of how the market actually performs.

Disposition Effect Examples

-The pile/filing cabinet/room that many people have, filled with instruction manuals for objects that have long since been replaced, tax returns spanning the last several decades, and every receipt we’ve ever received.  If we were really honest (and yes, I’m as bad as anyone about this), we’d come right out and admit that we could throw most of this stuff out and never even know it was gone, but part of our mind finds comfort in knowing that it is there.

-Self-Storage places, where you can pay by the month to stow some of your excess stuff.  The entire business model is designed on the assumption that you are willing to pay each month so that you can get stuff out of your house, but still want to be able to retrieve it at any time.  The convenience is almost certainly not worth the expense.

-As mentioned before, the willingness of investors to hold onto their losers and cut their winners short is also an example of the disposition effect at work.  While doing so may make you feel better (you can crow about the stocks you had that shot up while pretending the ones that declined can still increase), you’re doing the exact opposite of what you should be, investment-wise; holding the stocks that rise and getting rid of those that fall.

Beating the Disposition Effect

Beating the disposition effect is basically an issue of mind over matter.  You should know, in the rational part of your mind, that the chance of benefiting by holding onto many of your possessions is very low; unless your attic is filled with rare artwork or your basement holds pristine baseball cards from the thirties, most of your stuff is only as valuable as the use you can get out of it.  If you aren’t using it, particularly if it’s just taking up space in your house, dorm room, or apartment, you’ll likely be better off selling it for money with which you can purchase something you WILL use.  (Or better yet, why not invest the sales proceeds so you’ll have more money in the future?)

The simplest solution is to go through your possessions on a regular basis, figure out which you need and don’t need, and get rid of what you don’t need (selling it, throwing it away, trading it with someone else, whatever strikes your fancy, as long as it gets the item out of your living area).  If you’re a pack rat like me, it’s going to be tough, but it’ll be worth it to make your living space more, well, livable.

I’m not going to try to set out a precise definition of what exactly falls into the category of ‘needed’; you are going to have to give some thought as to what you consider necessary and unnecessary in your life and work from there.  For me, I would include regular use items (like my clothes and computer), seasonal items (holiday decorations and the like), mementos (things like report cards or art work I did as a child), and collectibles (so I have a category for my manga, really) as my ‘needed’ items, and everything else would be fair game to sell or trash, from books I haven’t read in years (which have no emotional value attached) to most of the DVDs I’ve accumulated in the past.

For investments, that same type of discipline will pay off.  Know when you make the initial purchase how you’re going to respond if the price goes down (Sell it when it drops a certain percentage?  Buy more when it dips lower?) and if the price goes up (Sell it when it gains a certain amount?  Wait to see how high it goes, selling when it starts to dip from its peak?).  Even the best laid investment plan won’t always increase in value, but if you make a plan for what to do in any event (and more importantly, you STICK to your plan), you’ll be much better in the long run.

Welcome once again to our continuing discussion of how your insane brain is costing you money.  You might think I’m exaggerating, but as we’ve seen already this week, there are a number of ways you brain doesn’t think entirely logically about money and investing.  One way that is particularly harmful to your investing and saving motivation is:

Hyperbolic Discounting

In its simplest form, hyperbolic discounting is an overemphasis of the old adage, ‘A bird in hand is worth two in the bush’.  When given the opportunity to have a relatively small amount now or delay our gratification for period of time and get a much higher amount of money, many people choose to take the smaller amount immediately.  The most commonly cited research (Green et al. 1994) shows that if people are given the choice between $50 today or $100 a year from now, most people will choose the $50 dollars today, in spite of the fact that the $100 will almost certainly still be worth more a year from now.

Interestingly, that same research found that if there was increased distance put between both rewards, if we are looking at the choice between $50 in five years or $100 in six years, most people will opt for the more financially beneficial option, choosing $100 in six years.  This is part of the ‘hyperbolic’ aspect of our mental process; there’s a much sharper drop off in perceived value in the near future (today vs. one year from now) than there is more distantly in the future (five vs. six years), even if the time period between the two events is the same.  (Besides showing the underlying false logic behind this process, it also illustrates a point we’ll use to make more logical decisions in the future.)

Hyperbolic Discounting Examples

-Most importantly for a blog about investing and saving, hyperbolic discounting causes people to value their current spending more than their future wealth.  As a result, given the choice between spending more today and investing more for tomorrow, most will opt for the former.

-Discounting future payments also causes people to opt for lump sum payments rather than defined periodic benefits, even if the defined benefits are much higher than the lump sum.  (I understand that there can be circumstances beyond the relative values of each type of payment that determine which method someone would prefer; this comment is more about people who look at $20,000 per year for 15 years vs. $100,000 immediately, and opt for the $100,000 without a reason other than it being a higher amount.)

-Opting to skip school or further training for an immediate job.  While it allows you to start earning money sooner, you’ll earn less over your lifetime than with more formal education; hyperbolic discounting of your future earnings potential strikes again.

Beating Hyperbolic Discounting

Remember how I told that when viewing the options several years in the future, people made the more logical choice?  That’s probably your greatest defense against hyperbolic discounting: put some distance between you and any of the options, so you don’t let the desire for immediate gratification overwhelm your common sense.  It might seem like a tough choice between spending money now and investing for the future, but imagine that you can’t use the money for a year; do you think you’ll still want to spend it?  If not, why do you want to spend it now?

Investing goes much the same way; it’s easy to rationalize putting it off until you’re older, or keeping the amount you invest as small as possible, but that leads to delays or avoidance of investing altogether.  Instead, try to take a longer term view, and look at what you could potentially have when it’s time to retire.  Would you rather have $1.9 million or $2.9 million in forty years?  (The difference between investing $4000 and $6000, respectively, and earning a 10% during that time period.)  How about choosing between $1.1 million and $2.9 million at retirement?  (The difference between starting to invest $6000 a year at 35 vs 25 years old, respectively.)  When you run some numbers to see your future net worth potential, it’s easier to see how relatively small sacrifices now can yield big returns in the future.

There, you know have a few mental tools to help you cope with hyperbolic discounting; the key is to try to repress the natural desire for immediate gratification and instead focus on the long term.  If you get skillful enough at doing so, you should be able to avoid the problems of hyperbolic discounting without any problem at all.

Welcome to the second in our series of posts about the ways your mind makes it harder for you to manage money intelligently.  Yes, unfortunately the nature way that human minds work can be one of your biggest obstacles to success with your money, so this week, we’re going to uncover some of the biggest mistaken beliefs and do what we can to correct them.  Today, we’re looking at a belief that powers any number of poor bets in Vegas.

Gambler’s Fallacy

The gambler’s fallacy is when you assume that long term probabilities will hold in the short term.  More to the point, you would assume that because something statistically unlikely has just occurred, the laws of probability demand that the opposite result will occur now.  One easy example is if you flip a coin five times and every time it comes up as heads, you might then assume that the next flip should be tails; after all, it’s ‘due’ to come up tails, right?

People still gamble with pennies, right?

Actually, as any statistician will tell you, it’s not.  Yes, over the long term (thousands or even millions of flips), the totals will be roughly evenly split, but within that series, there will be stretches where tails come up five, ten, twenty or even more times in a row, and similar stretches of heads.  You have no way of knowing if you are at the beginning of a much longer stretch or not; the only thing you know for certain is that there is an equal probability of getting heads or tails on any given flip.

Gambler’s Fallacy Examples

-Thinking that several red results in a row  in roulette means that black is due to come up, or vice versa.  The roulette ball doesn’t ‘remember’ previous results and ‘choose’ where to go next to look good statistically; every time, there’s the same possibility of getting a red as a black.

-Feeling that because your slots machine hasn’t paid out, it’s due to hit (and possibly to hit big) soon.  As with roulette, the slot machine (assuming it is fair and hasn’t been tampered with or altered in some way) doesn’t care whether the last five, fifty, or even five hundred spins have all paid out nothing; the chance that the next spin will pay out is exactly the same as it would be if the last results were all victories.

-Really, anytime you use the words ‘due’ or ‘should’ in conjunction to something based entirely on chance, you’re appealing to the Gambler’s Fallacy.  Past results have no effect on future probabilities, outside of our own perceptions.

Beating the Gambler’s Fallacy

The easiest way to beat the Gambler’s Fallacy is simply not to gamble.  Not only will your wallet thank you for not taking out money when all the odds are against you, but you’ll never have to worry about making improperly considered bets because something is ‘due’ to happen.

If you do gamble, or engage in other activities based on probabilities, you best defense will be to learn and understand those probabilities.  If you know, for example, that there is a 6 in 36 chance of rolling a seven in craps, you won’t be surprised when that’s the most common result.  You also won’t be surprised if, due to the quirks of the dice, you see a few dozen rolls with no sevens, or a dozen sevens in a row.  Remember, the dice don’t know what’s been rolled, and have no need to stick with statistical probabilities in the short run.

That’s pretty much all there is too it; don’t let recent trends convince you that things need to change soon in order to restore the laws of probability.  Trust me, the laws of probability are not going to be worrying about you.

Welcome to a week-long special about one of your greatest obstacles to financial success: your mind.  Unfortunately, many of the problems that we run into with money are caused by our minds; the current financial environment is not what our minds were designed to handle.  In the hopes of getting you to realize the logical flaws that plague our minds, we’re going to cover several of them this week, starting with one of the biggest, most prevalent ones:

Sunk Cost Fallacy

In a nut shell, the sunk cost fallacy is when you alter your behavior as a result of nonrecoverable money you have already spent. Unfortunately, the money you’ve spent is gone, and you can’t get those particular dollars back.  You have to do what you can to maximize your future enjoyment of your money, without regards to what expenses you had in the past.

Sunk Costs are like Sunken Boats; Usually Gone Forever

If we were completely rational beings, we would only be concerned about our future spending, not caring about what we spent in the past (at least, if there’s no possible way of getting that money back).  Alas, we humans are not that logical, and we ascribe value to what we spent already, regardless of what little effect it can have on our future financial situation.

Sunk Cost Fallacy Examples

-Spending more money to fix your current car than it would take to buy a new (or at least a good used car) car, because you’ve spent money fixing the car already.  (Side Note: I’ve nearly done this myself, spending more money than my car would be worth (I had bought it for $1000 several years before) to keep it running just a few more years, or more likely, months).

-Putting a nonrefundable down payment on an item at one store, before finding it somewhere else for lower cost (lower than the retail price minus the down payment).  If you opt for the less expensive item (which is the most economically sensible decision), then your down payment will be lost, an expense beyond the cost of the item.

-Holding a declining investment, while waiting for it to ‘break even’.  There are no guarantees in investing, and there’s no reason to think that your investment will necessarily come back, particularly to the fairly arbitrary point set when you bought it.  Investments don’t know how much you spent on them; good ones will increase in value and poor ones will decline, regardless of how much you spent to purchase them.

Beating the Sunk Cost Fallacy

The problem with the sunk cost fallacy is ascribing your past spending with equal weight to your future spending.  The best way to avoid falling into this trap is to re-evaluate your future spending while ignoring the money you’ve spent previously.  Ask yourself, ‘If I was making this purchase today, with no knowledge of what I’ve spent in the past, would I still make it?’  If it’s not worthwhile to make the purchase fresh, it’s not worth spending more money on it; chock up any down payments or previous expenses as the cost of doing business.

This argument applies with investing costs.  The cost of buying your investments can be considered sunk; if the investment declines, you have no way of getting your investment back.  You need to evaluate your investments on the basis of where they stand currently and where they will go in the future.  If the investment is declining, particularly if it is an investment like individual stocks that can go to zero, you need to ask yourself if you genuinely believe the investment will rise in the future.  Evaluate your investments as if you are putting in new money today, even if you aren’t, so you aren’t considering costs that are already sunk in your decisions.

As with any logical problem, it’s easy to fall into the sunk cost fallacy; our minds are designed to work in ways that aren’t conducive to our long term financial future.  You’re going to need to make some effort to avoid it.  Remember that money that’s been spent cannot be recovered in many cases, and as a result, shouldn’t factor into your future financial decisions.  While you shouldn’t forget the past, you should be sure to keep it in perspective, and not allow your past decisions to dictate future, less than ideal actions.