Blogs > Your Money

Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Tuesday, December 21, 2010

Your Emotions Can Cost You Plenty

Note: This article was previously published in the Oakland Press about two years ago. The issues discussed need to be reiterated from time to time.

Have you ever made a big gain in a stock and then seen your gains evaporate because you held on to it too long? Have you ever stayed with a loser until it was worth virtually nothing? Or maybe you couldn’t part with a stock you inherited from your Dad that made up a substantial portion of your total investment portfolio and then saw it rapidly drop in value. People often hold on to a stock with big gains because they don’t want to pay the capital gains tax and then lose 20% to 30% when the stock tanks for any of a number of reasons.

We have a lot of psychological hang-ups that impact not only our investment portfolios but many other areas of our financial well-being. A relatively new scientific study called behavioral economics, looks at how investors think, the mistakes they make and how they can benefit from understanding those mistakes. The book titled Why Smart People Make Big Money Mistakes – and How to Correct Them: Lessons from the New Science of Behavioral Economics by Gary Belsky and Thomas Gilovich (Simon & Schuster) is a very easy read that’s difficult to put down.

Behavioral economics attempts to understand the links between psychology and economics. By doing so, people can potentially enhance their enjoyment of life by understanding, and changing the way they make money decisions.

One example discussed in the book is the concept of “mental accounting”. The book presents two scenarios:

“Imagine that you’re at the racetrack for a day of gambling or at your favorite store shopping for a suit. Yesterday you won $ 1000 from your state’s instant lottery game. Will you bet more tonight than you would otherwise, or will you buy a more expensive suit?

“Now imagine that you’re once again at the racetrack for a day of gambling or at your favorite store shopping for a suit. Yesterday you realized that you had $1,000 in a savings account that you had forgotten about. Will you bet more tonight than you would otherwise, or will you buy a more expensive suit?"

The authors point out that “if you answered yes to the first question and no to the second –-- as most people would--- you’re prone to mental accounting.” Mental accounting involves putting different values on the same dollars just because they came from a different source. Why should lottery winnings be valued any differently that your hard-earned salary or savings? Nearly all of us do this.

Another of the basic principles of behavioral science discussed in the book is that people are “loss averse”. According to the authors- “the pain people feel from losing $100 is much greater than the pleasure they receive from gaining the same amount. This helps to explain why people behave inconsistently when taking risks. For example, the same person can act conservatively when protecting gains (by selling successful investments to guarantee profits) but recklessly when seeking to avoid losses (by holding on to losing investments in the hope that they’ll become profitable.)”

There are a number of psychological obstacles that keep us from acting in our best interest, financially. Just being aware of them can help. We highly recommend that everyone read Belsky and Gilovich’s book. If you don’t have the time, below are a few of the steps they recommend to improve your financial well-being:

(1) Raise your insurance deductibles to $ 500 or even $ 1000. You may be able to cut premiums by 10% or more.

(2) Pay off credit card debt with emergency funds. It makes sense to pay off 16% credit card debt with funds earning perhaps only 3% to 5% in a savings account.

(3) Switch to index funds in your investment portfolio. It’s very tough to beat the market. Mutual fund expenses and taxes eat away at your returns. Index funds are low-cost and tax efficient.

(4) Diversify your investments. Holding a diversified portfolio will reduce the volatility in your returns and help you avoid over-reacting to the market’s gyrations.

(5) Track your spending Understanding where your money is going will help you feel more in control of your finances and better understand the behavioral-economic factors that affect how you manage your money.

In summary, understanding a bit about behavioral economics can have a significant impact on your financial well-being.


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