If you’re reading this, chances are you’re a pretty bright person, particularly when it comes to money. After all, you’re here, reading a blog that discusses how to manage your money in a reasonable and intelligent manner, rather than simply hoping things will work out and you’ll be able to retire when you turn 65. Still, even for bright people like you (and me for that matter), money management can be tough; why does it seem that money, more so than almost any other area of life, is so confusing?
Why Smart People Make Big Money Mistakes looks at that very issue. It covers some of the basic lessons gleaned from behavioral economics, the intersection of economics and psychology that examines why people tend to be irrational with how they handle their money. It also provides some advice on how you can resist making those same mistakes, and correct them if you happened, like all humans, to have made some in the past. Does it actually help keep that irrationality under control? Let’s read on…
Why Smart People Make Big Money Mistakes opens with an Introduction that explains why the book was written. It points out several of the mistakes that people tend to make with their money, from putting money into ‘hot’ investments right before they become ice cold to keeping money in saving accounts that earn less than the rate of inflation. There is a short history of economics, and it notes that one of the assumptions made by traditional economics is that people are consistent, self-interested, and most importantly, rational in all their economic decisions. It points out that the lack of these traits in many of our economic actions led to the field of behavioral economics, an attempt to determine why people weren’t always rational with their money (pioneered by psychologists).
Chapter 1: Not All Dollars Are Created Equal
The first chapter opens with the idea that people tend not to view all dollars as fungible (that is, completely equivalent). Although the amount of things you are able to buy with $1000 is the same whether it came from your work earnings or a $1000 bill you found on the street (or got as a birthday gift), the former is considered more ‘real’ and less likely to be easily spent. This mental accounting tends to work against us, particularly when it comes to things like charges on credit cards (which are viewed as particularly unreal). The chapter ends, as all the chapters do, with a ‘How to Think and What to Do’ (HTWD) section that provides advice on avoiding the mistakes laid out in the chapter, in this case thinking about all purchases as if they were made with cash and imagining you had to work for all your income.
Chapter 2: When Six of One Isn’t Half a Dozen of the Other
Chapter two continues with how we tend to view money differently when viewed from different angles. A loss of $200 affects us more acutely than a gain of $200, for instance. It also discusses people’s tendency to take more risk when it means avoiding losses compared to making gains (known as Weber’s law), and our tendency to be concerned with money that we’re already spent and cannot recover (the sunk cost fallacy). The HTWD section for this chapter emphasizes looking to the future and ignoring the past (at least, when it comes to money we can’t get back).
Chapter 3: The Devil That You Know
You might already know that what people tend to prefer the familiar to the unfamiliar. The problem is that in many cases, the latter might actually be better for us, particularly in areas like investing. We don’t want to feel regret if we end up going to a worse investment (aka, regret aversion). Add in the fact that we tend to be overwhelmed when facing numerous alternatives like the thousands of mutual funds and stocks out there (decision paralysis), and we often stick with poorer choices than the others that are available. Some HTWD suggestions include remembering opportunity costs (and that a less than ideal decision can still be better than not making a decision at all) and playing devil’s advocate to yourself to consider decisions from all angles.
Chapter 4: Number Numbness
Inflation can pretty quickly lower the spending power of your money, as I probably don’t need to tell anyone reading this. If you don’t invest aggressively enough to keep up with inflation (or better yet, beat it), your money will be worth less in the future, even if it has nominally increased in value (this is what they call ‘money illusion’, by the way). Add in the difficulty many people have in calculating (or understanding) the odds in many aspects of money, and there’s a lot of trouble with numbers going on. Hence, the HTWD sections mainly focuses on ways to look deeper into the statistical aspect of money issues, like making sure that the success of a mutual fund manager wasn’t a simple fluke and being sure to invest enough to avoid inflation eating through your savings.
Chapter 5: Anchors Aweigh
Do you have a friend (or family member) who is fiercely supportive of one political party, and will belief anything positive about that party and its members (and conversely, anything negative about their opponents)? Congratulations, you’ve seen confirmation bias in action, that is, the tendency for people to find information that confirms their existing beliefs true and the info that disproves those beliefs false (the latter being ‘disconfirmation disinclination’). This is part of the concept called ‘anchoring’, where we latch onto the first information we are presented and tend not to move far from it. Any time you’ve been given an initial price for a negotiable object (anything from a garage sale nick-knack to a house) and start from that point in how you value the object rather than finding a more objective value shows how anchoring can affect you. As for HTWD, some things to do include getting multiple opinions, double-checking the information you have, and to check that you aren’t using exceptionally high (or low) trends as the starting points for your judgments.
Chapter 6: The Ego Trap
We tend to think too highly of our skills. It’s natural, of course; if we didn’t think highly of ourselves, we’d have a self-esteem problem. When it comes to financial matters, though, this high confidence can lead to numerous mistakes, from assuming we are in better financial shape than we actually are to making less money when selling a house because we don’t use a broker, trusting our own ability to sell our house. And of course, there’s a tendency to put the blame for any failures on someone other than ourselves; as one subheading noted, we tend to look at successes and failures as ‘Heads I Win, Tails It’s Chance’. The HTWD section focuses on keeping track of your financial wins AND losses carefully, so you have a better idea of just how good you really are at stock picking, and getting a second opinion before making any big decisions.
Chapter 7: I Herd It Through the Grapevine
The final chapter focuses on the tendency of people to move and react in groups (or ‘herds’, hence the title). Particularly with stock investing, there is a tendency to buy in after many people already have bought, and to sell when most people have already bailed on the stock (or the market in general). This ends up resulting in a lot of ‘buying high, selling low’, the exact opposite of what you should do to succeed in investing. As for the HTWD, as you might guess, the major advice is to avoid the crowd, limit your exposure to financial news (or ‘noise’), and look for an opportunity to go against the crowd when possible.
Conclusion: Now What?
With the bulk of the book over, the conclusion is divided up into two sections. The Principles to Ponder provides a review of most of the concepts included in the book and how they can negatively affect your monetary life. The Steps to Take provides some solid actions that can be done to improve your finances and avoid some of the pitfalls laid out in the book.
Postscript: Psychic Income
The book rounds out with a short postscript that emphasizes two main points about applying all these lessons. First, try to pick your battles, as you won’t be able to do all (or even most) of what is suggested in the book at once. Second, go easy on yourself, as most people have made similar mistakes to you at some point.
- Insightful and Informative: There’s a lot of good information contained within this book, all of which provides an insight into how you can better manage your money.
- Well-Researched: Throughout the book, you can find numerous studies cited and lots of interesting research data provided to support the suggestions provided.
- Witty and Entertaining: While many economics books tend to be dry and boring, there’s quite a bit of humor and interesting references within this one. (Chapter 4 starts with a Simpsons reference, always a good sign in my book.)
- Some Chapters Jump Around: In several of the chapters, there are multiple issues covered at once, and a tendency to go from one to another and then back. This makes it harder to follow the overall flow of the book.
- A Few Pieces of Advice Are Less Than Stellar: The advice to pay off your credit card debt with emergency funds is a particularly glaring example; while a good idea, mathematically, it will leave you dependent on getting money from the credit card company (possibly at much higher interest rates, if you need a cash advance) if you run into an emergency.
Why Smart People Make Big Money Mistakes is a good introduction to behavioral economics, and the concepts that are studied in that field. It provides plenty of interesting anecdotes, useful advice, and plenty of food for thought. It’s definitely something I’d read again (and not just because I enjoy these topics).