Tuesday, October 11, 2011

Why Smart People Make Big Money Mistakes

Gary Belsky & Thomas Gilovich

This particular book is focused on addressing common financial practices that most, if not all, people tend to use when dealing with their personal financial transactions. The transactions that are discussed in the book include those that deal with personal budgeting and investing. Whether we realize it or not we are guilty of making simple mistakes when dealing with money that can be more costly to us in the long-run. The reasons for why we don’t fully realize our mistakes is due to the fact that we have created a mindset that we fully understand how to properly allocate funds as well as how to make intelligent financial decisions when in reality we really are clueless to the fact that we aren’t fully reeping the potential benefits of our everyday financial transactions.

While reading the first chapter of this book I did not agree with the theories presented by the authors. The first chapter discusses a scenario in which a young man, while visiting Las Vegas, uses a $5 chip to play one hand of roulette and exponentially wins until he has $262 million in his possession. He figures he can continue this win streak and places all of his money on 17, unfortunately his streak ends and he ends up losing all of his winnings. He then goes back to his hotel room and his wife asks him if how he did on his gambling adventure and he tells her that he only lost $5. The authors argued that the man in fact did not lose $5 of his own money but instead $262 million of his own money. The authors claim that the theory of gambling with “house money” (money won from the casino) is in fact wrong because the amount of winnings that are accumulated actually belong to the gambler, not the casino. I did not agree with this argument but as I continued to progress through the book I began to understand that the authors were claiming that the mindset that we typically have of gambling with “house money” is what causes us to undervalue the amount of money in our possession when in reality it is in fact our money.

An additional misconception that investors tend to have regarding making sound investment decisions is that investing in mutual funds is the safest and potentially best method of investment in the market. According to the studies presented by the authors of the book the stock market has performed better over time than the mutual fund market, even though it subject to high volatility. The reason investors choose to invest in mutual funds is because of “loss aversion”. Loss aversion is simply the mindset we have when opting to select an investment option that seems to have the least potential of suffering a heavy financial loss. The authors of this book recommend that we break this mindset and choose to invest in stocks, most notably that we invest in index funds. The reason for this is that stocks have performed better over time as compared to mutual funds. Mutual funds tend to be more conservative since a single mutual fund consists of a wide range of diversified stocks, but only receive conservative returns. Single stock investments, on the other hand, are more volatile and risky but can lead to greater returns.

In regards to investing in stocks over mutual funds, Belsky and Gilovich suggest that we don’t follow the activity of our investment portfolio so attentively. The authors present studies performed by numerous researchers that show that investors who view the activity of their portfolio not even daily, but weekly, receive lower returns on their investment than those who only check their portfolio’s status a few times a year or even once a year. The idea behind this is that when we check our portfolio daily we become consumed by all of the information that changes the market on a day-to-day basis. It is better to view the market over a long-term period rather than over a short-term period.

Yet another recommendation by the authors of this book is that we don’t fall into the “herd”. The authors suggest that we don’t be so quick to follow the rest of the investing community when deciding to buy or sell a single security. Often times the majority of investors in the market are not conducting any research on their own in order to make their decisions but instead rely on watching what everyone else in the market does and then choose to buy or sell along with the rest of the investing community. The best way to avoid this type of investing behavior is to conduct your own research and form your own educated opinion in the choosing the appropriate action of whether to buy or sell a certain security.

Belsky, G.; Gilovich, T. (1999) Why Smart People Make Big Money Mistakes-And How To Correct Them. New York: Simon & Schuster.

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