Thursday, July 5, 2012

Notes On Why Smart People Make Big Money Mistakes and How to Correct Them

Lesson 1: Mental Accounting: The tendency to value some dollar less than others and thus to waste them. The inclination to categorize and treat money differently depending on where it comes from, where it is kept, or how it is spent. 

Example: 1. Amateur gamblers view winnings as an entirely different kind of money and was therefore more willing to make extravagant bets with it- playing with House Money.
               2. Spending more with bonus and lottery winning (found money).

Psychological root: It is intellectually difficult, and emotionally taxing, to calculate the cost of every short-term transaction. So to cope with this daunting organizational task, people separate their money into mental accounts, necessarily treating a dollar in one account differently from a dollar in another, since each account has a different significance

Harmful consequence: Too quick to spend, too slow to save, or too conservative when investing.  

Another way mental accounting can cause trouble is the resultant tendency to treat dollars differently depending on the size of the mental account in which they are stashed, the size of the particular transaction in which they are spent, or simple the amount of money in question. For instance, when you are spending $25,000 on a car, a $500 back-up camera seems inconsequential.

We are also subject to the subconscious preference to "integrate losses. " When you incur a loss or expense, you prefer to hide it from yourself by burying it within a bigger loss or expense, so that the pain of spending $500 for a back-up camera is neutralized to a great extent by the larger pain of spending $25,000. That's why electronic stores and car dealers sell extended warranties or service contracts. 

Implication: When making big purchases, do not buy any complementary products without thinking about do you really need it if not for this big purchase. 

Credit cards are dangerous mental accounts because credit card dollars are cheapened because there is seemingly no loss at the moment of purchase, at least on a visceral level. The money we charge on plastic is devalued because it seems as if we are not actually spending anything when we use the cards. 

How to cope with this psychological bias: 

  • Think about how much money you would pay if using cash instead of cards. 
  • When making big purchases, do not buy any complementary products or services without thinking about do you really need it if not for this big purchase. 
  • Train yourself to wait a while before making any spending dicisions. 
  • Treat all money as earned money. 
Lesson 2: Prospect Theory: Decision under Risk. "Loss aversion" and "sunk cost fallacy".

Loss Aversion:Willingness to take more risk if it means avoiding a sure loss and to be more consevative when given the opportunity to lock in a sure gain.

Example: In a game where you know you have can choose between either a guaranteed a gain of $500 or flip a coin and either receive a $1000 or nothing depending on the result, most people choose the guaranteed $500. However, if it's between a guaranteed $500 loss or flipping a coin for either a $1000 loss or no loss, most people will choose to flip a coin.

Weber's law: The impact of a change in the intensity of a stimulus is proportional to the absolute level of the original stimulus. For instance, the difference between nothing and $500 is greater psychologically than the difference between $500 and $1000.The difference between nothing and $500 loss is greater psychologically than the difference between losing $500  and losing $1000. 

Prospect theory says that people generally do not assign values to options based on the option's expected effect on their overall level of wealth: For example, if you have a loss of $500 on your portfolio with MV of $50,000, you don't consider the loss of $500 as 1% of the portfolio, you see it as $500 loss in its absolute value. 

When people view a decision as one of a preference, they tend to focus on the positive qualities of the options. When making a decision regarding cancellation, people tend to focus on the negative qualities of each option. What's important to understand is that people feel more strongly about the pain that comes with loss than they do about the pleasure that comes with an equal gain (about twice as strongly). 

The loss aversion attributes to why people sell the winners too soon and hold on to losers too long. This is creative mental accounting at its worst: the unrealized losses are segregated in a separate account precisely because they are unrealized. 

Sunk Cost Fallacy: Focusing on money already spent and ignoring the future costs and benefits. The more the sunk cost, the more likely you will be focusing on money already spent.

Investment Implications:
Loss Aversion: Between a guaranteed $500 loss and the possibility of "recovering your loss" or "$1000 more loss", do the research and incur the $500 loss and move on. Especially with troubled companies or turnarounds.

Sunk Cost Fallacy: Don't fixate on the cost, focus on current value.

Lesson 3: Dealing with Decision Paralysis. 

1. Decision paralysis is attributable to the fear of regret and a preference for the same old thing.
2. A decision to delay an action, or take no action at all, becomes more likely when there are many attractive options from which to choose.
3. The longer you defer making a decision, the less likely you are to ever get over your hesitation.
4. "Extremeness Aversion": People are more likely to choose an option if it is an intermediate choice within an group, rather than at one extreme end.
5. Regret aversion, decision paralysis, and the status quo bias combined can influence your financial decisions and to cost you money. Examples, leaving money in a bank account rather than investing; staying in a low-paying job rather than making a switch to a better job; failing to sell a stock only to see it drops further; delaying the purchase of a stock only to see it rises later.

To deal with decision paralysis:

  • Write the analysis down. 
  • Change your frame of reference to a more neutral one
  • Reverse the context in which you perceive the choice at hand. Turn a decision of which option to reject into one of which option to select and vice versa. 

Lesson 4: Number Numbness

1. The tendency to ignore inflation.
2. Failing to understand the role of odds and chance in life can lead you to make unwise investment and spending decisions. The tendency to disregard or discount the overall odds in a give situation is what Kahneman and Tversky called "ignoring the base rate."

  • Exceptions to the overall odds are often more easily to called to mind. For eg, people avoided the beach after seeing the movie Jaws. 
  • Overconfidence and ignoring base rate, particularly because of a misguided reliance on memorable events or on inconclusive information, contributes in a variety of ways to poor financial decisions. Examples include amateur investors think they can forecast the future of commodity market, despite 75% o f professional and amateur commodity investors lose money. Or people shell out for life insurances. 
  • If you flip a coin 20 times in a row, there's an 80% chance that you will get three heads in a row at some point during the flipping and 50% chance of getting 4 in a row and 25% chance of a streak of 5. 

3. "Bigness bias,", the way in which indifference to small numbers can cost big bucks, especially over time. This is related to mental accounting.

Lesson 5 Anchoring Aweigh

1. Anchoring is the clinging to a fact or figure that should have no bearing on your judgement or decisions. The difficulty that result from anchoring, furthermore, are often compounded by a second problem known as
confirmation bias or, disconfirmation disinclination. People tend to search for evidence, treat kindly, and be overly impressed by information that confirms their initial impressions or preferences. 
2. Anchoring can be particularly powerful because you often have no idea that such a phenomenon is affecting you. 
3. Two types of anchoring are particularly dangerous. 

  • Most people are particularly vulnerable to the effects of anchoring when they know precious little about the commodity in question. You are particularly prone to anchoring a particular dollar figure when you are swimming in unfamiliar waters. So if you don't know the intrinsic value of a stock, you are more likely to cling to the price you paid. Or you don't even have to buy the stock to anchor on a price. For eg, in the early 1990s, U.S Surgical Corp increased fourfold to $131.50 in just one year. Subsequently, when the share price dropped to $56.50 in 1992, many people rushed in. 
  • The other type of anchoring is when you know enough about a subject but got sucked in anyway. A good example would be you've calculated the intrinsic value of a stock to be $80, so you purchased at $60 and once it reaches $80, you sold it for a profit of $20. Later on the fundamentals of the stock got a little better so you recalculated the intrinsic value to be $90 and you were waiting for a good entry point. Finally the day came: the company missed the quarterly earnings projection by $0.01 even though it posted record earnings and Wall Street dumped the stock. Within two days it went from $82 to $65. You vividly remember that you paid $60 last time and you told yourself it would drop to $60 this time. Unfortunately the day never came and the stock flew from $65 to $92 while you were living in your little fantasy. 
  • Anchoring is so powerful in investing. It doesn't matter if you are selling or buying. How many times do you consider prior year's highs when determining the target price? How many times do you "anchor" to the previous "lows" when you are trying to enter a position. How many times you just want to break even and once a losing position gets back to the cost basis, you sold the stock only to regret it later.
4. To overcome anchoring, knowledge is key.
5. The best way is to find "DIS-CONFIRMING EVIDENCE"!
7. Another way to overcome anchoring is to broaden your board of directors.
6. The most insidious problem with confirmation bias can be summed up with a simple statement: people often hear what they want to hear.

Last But Not Least:: The Ego Trap

  • Planning fallacy: The inability to complete tasks on schedule. 
  • A little knowledge can lead to a lot of overconfidence. 
  • The problem often arise from the fact that people over-confidently confuse familiarity with knowledge. 
  • Especially watch out during a bull market because your ego will also be boosted even though it's more likely than not the overall market's exuberance, rather than you investment skill, that contributed to your portfolio gain.  

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