One of the things that always fascinates me is the human mind and how it works. We are rather interesting creatures. Unfortunately, we're not all that rational; while this is good news for psychoanalysts, it does make it harder for the rest of us to function properly without our minds sabotaging us.
Case in point, the Peltzman effect. The short version of the Peltzman effect goes like this: people adjust their behavior to new safety regulations in ways that negate the intended effects of the legislation. As a result, any attempt to legislate safety will be largely inefficient, because people will respond to laws designed to increase their safety by behaving in a more unsafe manner, thus negating the legislation's intended effects.
For but one example, consider mandatory seat belt use. In theory, the requirement that everyone use a seat belt while driving should cut down on severe injuries and fatalities from automotive accidents. In practice, there's an unfortunate tendency for people to drive more aggressively while wearing seat belts than they would if they were unbuckled.
Of course, you can probably think of plenty examples of the same think happening without the need for regulators to be involved. When was the last time you were driving and saw someone driving a huge SUV in an obviously unsafe manner? It's not too much of stretch to hypothesize that part of the reason that people take more risks in those situations is because their feelings of safety lead them to behave in ways that decrease their safety, as well as the safety of those around them. Their own sense of safety leads them to behave in a way that ultimately decreases their safety.
Peltzman and Your Money
As you might have guessed by now, there's plenty of applications that this sort of psychological effect can have on how you manage your money. The Peltzman effect, or similar methods by which we ‘trick' ourselves about where our finances stand and the amount of . To cite just a few examples:
-Getting a raise, and thinking that you can increase your spending even more as a result. This type of lifestyle inflation can easily take its toll, not only decreasing the money you save and invest for the future, but also increase your perceived needs for what you need in life.
-Keeping too much of your investment money in riskier investments. When we have long runs of high investment returns, there's a bad tendency for many people to keep their money in investments like stocks that offer greater average net returns, but also have a greater risk of losing money.
-Investing without doing proper research, because of an agency rating. Possibly the most topical example I have, there is an unfortunate tendency for people to invest somewhat blindly, putting money into investments that are highly rated without doing their own research. *Cough*Credit Default Swaps*Cough* The existence of outside agencies rating bonds and other investments led to increased confidence in them, leading to increased amounts of money that are put into the investments than is actually important.
Fighting the Peltzman Effect
So, now that you have a better idea of what the Peltzman Effect actually is, and ways that perceptions of safety can make you invest and otherwise handle your money in a less safe manner, you're probably thinking about how you can fight this psychological effect. Well, you're in luck, as I have a few suggestions to help you out.
First, keep a close eye on how you invest and otherwise handle your money. It's easy to lose track of where you stand with your investments at times, and when you do, then you can end up letting psychological factors unduly influence your investment choices. As the old School House Rock videos used to say, ‘Knowledge is Power'!
Second, know the real risk of your money choices. If you followed the first step and know what is going on with your money, you should be able to evaluate the risks that you are taking on. Do your investment choices have the possibility of dropping much more than you can afford before you need to use the money? Are you investing too conservatively to achieve the growth that you need? Is your spending increasing much faster than your income? Answering yes to any of these questions likely means that the risk you are taking is much higher than what is justified for your situation.
Third, make the necessary changes so that you can get your risk level back in line. There's no way to completely eliminate all risk, but you can ensure that you are only taking on the amount of risk you need to achieve your goals. (If you do want to take on more risk, then you should limit that risk taking to a portion of your portfolio that you can afford to lose.)
Finally, don't think that you can stop after doing one evaluation. As with so many money management tasks, you can't let up on keeping track of where you stand with the risk you take on. Don't let undesirable risk sneak into your investments, particularly if you don't know exactly the level of risk that is involved with your money choices.
There you have it; a few methods to keep the Pultzman Effect (and ways by which your mind adversely influences your investment choices) under control. Good luck keeping your mind in check; I know that you can do it.