THE TEN MISTAKES TO AVOID WITH MONEY First-rate minds make fifth-rate financial decisions. Why? The answers will save you big money.
(MONEY Magazine) – Face it: no matter how smart we are, we all make dumb mistakes about money that cost us thousands of dollars every year -- often without being aware of it. The culprits: a series of mental blind spots and knee-jerk reactions that befog most financial judgments. But we can learn to recognize and avoid these pitfalls. Here's how to wise up:
Give high and low estimates of the number of movie theaters in the U.S.S.R. Choose numbers just far enough apart to be 90% sure that the true number lies between them.
What do Soviet moviehouses have to do with your finances? Nothing directly, of course. But the answer you give to that question could reveal a great deal about how you make financial decisions -- and help you make better ones. Want to see why? Reread the question now and jot down your answer. We'll come back to it in a moment. People make financial mistakes for many reasons. They listen to bum advice. They misread the market. They succumb to greed, fear, laziness and any number of other human foibles. This story isn't about any of those foul-ups -- the stock in trade of self- appointed experts who blather on about the ''psychology of money making'' and charge high fees for all-too-obvious advice. It focuses instead on more common and insidious mental errors that just about everyone makes over and over again, partly because people aren't aware of them. These mistakes are inbred, the universal byproduct of the shortcuts that evolution built into our mental machinery to enable us to cope with the endless intricacies of life. ''They are like optical illusions,'' says psychologist Amos Tversky of Stanford, who, along with Daniel Kahneman of Berkeley, helped pioneer the study of them nearly two decades ago. ''Fortunately, we can learn to recognize and compensate for many of the most common ones.'' Take the question about the Soviet moviehouses. Chances are you first decided on a ''correct'' answer and then stretched your high and low estimates in order to cover your ignorance. But here's the real answer: 150,000. If that doesn't fall between your high and low estimates, don't feel bad. When J. Edward Russo of Cornell and Paul Schoemaker of the University of Chicago put questions like that to more than 1,000 business executives, those professionals missed the mark about half the time. The problem is overconfidence. ''Even though people know next to nothing about the Soviet movie business,'' says Schoemaker, ''they don't spread their estimates far enough apart to account for that. They put great weight on whatever they do happen to know, and they assume that what they don't already know just isn't important.'' Often, the same overconfidence skews financial decisions. Take the case of Herb Ridderbusch, head of the Seattle chapter of the Stocks and Bonds Special Interest Group of the American Association of Individual Investors. In 1987 Ridderbusch became so convinced that European stock markets were poised to rise that he put $2,300 into three single-country equity mutual funds that invested in Italy, Germany and France, respectively. After watching the value of his shares drop $600 over the next two years, he sold out last July -- just in time to miss a gain of 123% in the ensuing six months. ''I was right about the direction of the markets but overconfident of my timing,'' says Ridderbusch, 57. In general, many short-term bets on stock prices, interest rates and currency fluctuations suffer from the same flaw. Overconfidence also helps explain why you may sometimes fall for clever salesmanship. ''A seller will give you just enough information to justify your purchase or investment, and leave out other facts,'' says Schoemaker, co- author with Russo of Decision Traps (Doubleday, $19.95). Your high opinion of your own judgment clinches the deal -- outweighing your truly limited knowledge and the fact that your main source of information is the seller, who is obviously biased. Mark Jorstad, president of a Seattle jewelry company, lost $38,000 of his firm's retirement money by investing in real estate loans that offered unusually high yields of 12%. The firm that made the loans went bankrupt in 1986, and the company president was convicted of fraud. ''They told me there was no risk because the loans were backed by real estate,'' says Jorstad. ''But I should have realized that there was some risk involved. How else could they offer those rates?''
Mistake 1 Innate overconfidence makes us too quick to assume that what we know is accurate and complete -- even when our information is sketchy. Advice: When you confront an important investment or purchase, write down everything you know that might affect its outcome. Next list what you don't know that might also be important. Ponder the lists, and then gather whatever additional facts you need to make a well-informed decision. And be humble: however long your list of things you don't know, the true list is probably much longer.
The Huns under Attila invaded Europe and penetrated deeply into what is now France, where they were defeated and forced to turn eastward. Answer these two questions:
1) Did these events occur before or after the year A.D. 812? (Note: The number 812 was chosen arbitrarily by adding 400 to the last three digits of a randomly picked MONEY staffer's phone number.) 2) In what year did Attila's defeat occur?
The first question is a setup, but your answer to the second one may be revealing. Chances are, you guessed Attila was beaten close to the year A.D. 812 -- even though we told you the figure was meaningless. Can an irrelevant number like that influence people's judgment? You bet. During the past three years, Russo and Schoemaker have put this problem to 500 M.B.A. candidates, asking them to compute the first date by adding 400 to the last three digits of their own phone numbers. When that date happens to range between 400 and 599, the students guess -- on average -- that Attila was beaten in A.D. 629. But when the date is between 1200 and 1399, they guess A.D. 988. (Attila's real Waterloo was in A.D. 451.) As Werner De Bondt, a finance professor at the University of Wisconsin at Madison, observes dryly, ''When you give people data -- any data -- they use it.'' Kahneman and Tversky call this phenomenon ''anchoring'' because a figure -- like the 812 used in our example -- serves as an anchor from which people's subsequent judgments do not stray. Ever haggle over the price of a house? If so, the phenomenon will be agonizingly familiar. The seller's asking price acts as an anchor -- although the buyer knows that such figures often are inflated. Even professional real estate agents can be swayed, as University of Arizona professor Gregory Northcraft and Northwestern University's Margaret Neale discovered. When they took agents to a house, gave them a talk on neighborhood home values and told them that the asking price was $65,900, the agents said the home was worth $66,755, on average. But when a second group of pros heard an identical spiel -- except the asking price was given as $83,900 -- they pegged the value at $73,000 -- more than $6,000, or almost 10%, higher than the first group's estimate. Obviously, anchoring can help sellers -- but it can also hurt them. Take the case of Jim and Janet Cohen. In 1982 they got an offer of $160,000 almost immediately after putting their Hollywood, Fla. home on the market. But they turned it down because a friend who lived nearby had recently sold for $200,000. ''Our house wasn't as nice as his,'' says Jim, an oncologist. ''But we felt that if he had gotten $200,000, we should hold out.'' Result? It took two years to find another buyer -- at $135,000, or $25,000 less than the original offer. Anchoring -- and the use of inadequate data -- also encourages people to set unrealistic investment goals. ''Many people who got used to double-digit returns on bank CDs during the early '80s couldn't adjust to lower yields when interest rates fell,'' says Len Reinhart, director of independent advisory programs at Shearson Lehman Hutton in Wilmington, Del. Some of them turned to junk bonds -- and as a result have suffered devastating losses during the past year.
Mistake 2 We rely on data that shouldn't count to make decisions that do. Advice: When a decision involves figures, such as an asking price or an anticipated rate of return, dig for more than one number that seems relevant. , For example, hire a $150 appraiser before you make a five- or six-figure offer on a home; his estimate will help offset the influence of the seller's asking price. Or when investing in the stock market, remember that stocks have returned about 10% annually over the past 60 years, far less than the exceptionally high 17% returns of the past decade -- and set your own goals accordingly.
Which type of death is more common in the United States: murder or suicide? Murder, right? Typically, 70% of people give that answer, according to Sarah Lichtenstein, a psychologist at Decision Research, a nonprofit institute in Eugene, Ore. Yet the truth is that suicides outnumber murders about 3 to 2 (30,796 to 21,103 in 1987). So why do people think murder is more common? Because murders attract news coverage; we hear about them far more often. In general, people tend to overestimate the frequency and importance of dramatic, memorable events -- and underestimate the likelihood of dull, mundane ones. For example, the 1987 stock market crash -- and more recent volatile one-day market moves -- have reminded many investors forcefully that stocks are subject to wide price fluctuations. As a result, some cautious investors have moved all of their assets into undiversified portfolios of ''safe'' investments such as bonds. They don't realize that an all-bond portfolio carries its own risk. During the five years that ended Dec. 31, total returns on long-term Treasury bonds fluctuated more than two-thirds as much as returns on Standard & Poor's 500-stock index. ''Stock market trouble usually is bigger news than bond market trouble,'' says Roger Gibson, a Pittsburgh money manager. ''But bonds can be volatile too.'' Investors who buy or sell a stock on striking news -- a hot product, a potential takeover or a newsworthy disaster -- fall into the same trap. ''Some of my clients who are Upjohn employees loaded up on the stock in early 1987 because of rumors that the FDA would approve Rogaine, the firm's antibaldness drug,'' recalls Ronald Wiser, a financial planner in Kalamazoo, where Upjohn is based. Rogaine was indeed approved. But though the drug's sales are now growing steadily, the stock has returned only 1.1% over the past three years, compared with 25.2% for the S&P 500. Still, news continues to rule. Says Wiser: ''A lot of my clients are holding on to the shares they purchased because they've heard vague rumors of a merger with Du Pont or Rorer Pharmaceuticals.''
Mistake 3 We confuse memorable events with the big picture. Advice: Discount random experience. If you hear good news about a company, for example, don't call your broker to buy the stock. Ask instead for an analysis of the firm as a whole -- and keep digging until you are sure that it's a good buy.
Steve, a 30-year-old American, has been described by a former neighbor as follows: ''Steve is very shy and withdrawn, invariably helpful but with little real interest in people or the world of reality. A meek and tidy soul, he has a need for order and structure and a passion for detail.'' Which occupation is Steve more likely to have: that of salesman or that of librarian?
Richard Thaler, an economist who heads Cornell's Center for Behavioral Economics and Decision Research at the Johnson School of Management, has asked this question -- devised by him and Kahneman -- of more than 1,000 executives at his decision-making seminars. Typically, about two-thirds figure Steve for a librarian. Sounds reasonable. But consider these facts: there are upwards of 14 million salespeople in the U.S. and only 188,000 librarians. On that basis, Steve is about 75 times more likely to hawk something for a living than to tend books -- even if his personality suggests that he would be a lousy salesman. If you figured Steve for a librarian, you made the common mistake that Kahneman and Tversky call ignoring the base rate, or overall odds -- a misstep that can easily lead to financial trouble. For example, when a broker talks about the spectacular profits in commodities, ask for a figure that is far more predictive of your own chances of success -- the percentage of investors who lose money trading commodities through a broker. That figure is a daunting 70% -- extremely discouraging odds. So why do so many people fall for commodities? As Charlotte Taylor, president of the small-business consulting firm Venture Concepts of Washington, D.C., says: ''Most investors think statistics apply only to other people.''
Mistake 4 We ignore the odds even when they're stacked against us. Advice: Before you undertake a difficult venture or risky investment, study relevant background data to weigh your chances. Don't dismiss discouraging evidence. Instead, try to understand it. Maybe you can beat the odds -- but only if you know exactly what problems you are going to run up against.
A basketball player in prime condition has hit 50% of his shots during his five-year pro career. His last three shots have been good. You are asked to bet $1 on his next one. Should you bet that he will hit it or miss it?
Any fan can tell you that basketball players often shoot in streaks. They have the ''hot hand'' and can't miss -- or they ''go cold'' and seemingly can't buy a basket. Coaches scream at players to feed the ''hot hand'' and freeze out the cold one. Unfortunately, the coaches (and players and announcers and fans) don't know what they're yelling about. The odds that a superb player who normally makes half his shots will sink his next try are exactly even. His current three- basket streak is simply a matter of luck, as Tversky and two other psychology professors -- Thomas Gilovich of Cornell and Robert Vallone, then at Stanford -- proved by studying game stats. They analyzed field-goal records of the Philadelphia '76ers and three other pro teams and found no evidence for the ''hot hand.'' Even Philly guard Andrew Toney, whom sports announcers had anointed for years as a ''streak shooter,'' didn't make more shots in a row than would be expected from his overall field-goal percentage.
So why do players seem to shoot in streaks? Random streaks occur much more commonly than most people think. When you flip a coin 20 times, for example, there is almost an 80% chance that you will get three heads or tails in a row. Similarly, when a player with a 50% scoring average takes 20 or more shots in a single game, as many do, his odds of a streak of three are roughly 80%. ''People find patterns where they don't exist,'' says Gilovich. ''As a result, they misread the evidence of everyday life.'' Investors may recognize a parallel in mutual fund performance. While some funds do well by dint of superior management, even mediocre funds -- like scrub ballplayers -- sometimes enjoy prolonged streaks. De Bondt of Wisconsin estimates that about 140 of the 1,100 mutual funds that invest in stocks are likely to outperform the average equity fund three years in a row, just as a matter of chance.
Similarly, a single brilliant performance may not reflect long-term success. Take Joe Granville's Granville Market Letter, which last year turned in the best record among 120 newsletters rated by the Hulbert Financial Digest. As editor Mark Hulbert points out, Granville's victory resulted largely from an extraordinary 1,198% gain in his options portfolio -- the same kind of portfolio that sustained losses of 46.6%, 96.8%, 89.7% and 97.8% in the four ! prior years.
Mistake 5 We underestimate the role of chance in everyday phenomena. Advice: Don't assume that past investment results are meaningful, especially when you are considering short-term numbers. When choosing a mutual fund, for example, consider other factors -- such as how volatile it has been over the past three to five years and whether its holdings will help balance your total portfolio. And be sure you can afford to sustain the loss if the fund happens to go sour.
1) You go to a store to buy a clock radio. It carries a price tag of $50. You discover that the same clock radio is on sale for $25 at a branch of the store 10 blocks away. Do you go to the second store to get the lower price? 2) You go to a store to buy a stereo system. It is priced at $1,525. You discover that you can buy the same stereo system for $1,500 at a branch of the store 10 blocks away. Do you go to the second store to get the lower price?
Thaler says that three out of four people would go to the second store to save on the clock radio, but only one in five would bother for the stereo system. Both choices, however, boil down to exactly the same proposition: would you walk 10 blocks to save $25? Salesmen of big-ticket items are expert at playing on this human tendency to treat a dollar with less respect when making a big purchase. In 1986, for instance, a dealer talked Bob Van Laarhoven of Phoenix into paying an extra $700 for an extended warranty on his new $10,300 Suzuki Samurai. ''I didn't need the warranty,'' says Van Laarhoven. ''But the $700 didn't seem like such a big deal at the time.'' Such mistakes also occur when we negotiate open-ended projects, like a home renovation. Would you pay $2,500 for a whirlpool bathtub in your second bathroom? Probably not, normally. But what's an extra $2,500 when you're shelling out $40,000 for a remodeling? Likewise, thousands of dollars may seem like peanuts when you're negotiating to buy a home. ''Many home buyers will throw in an extra $3,000 just to get the deal done 10 minutes sooner,'' says Vincent Hanley, a real estate lawyer in New York City.
Mistake 6 We don't always treat a dollar as a dollar. Advice: When you are making a sizable purchase or investment, consider each component separately. For example, if a car salesman offers to tack on a $500 option, imagine that you already own the car. Would you be willing to pay $500 for that option? Similarly, if you're asked to throw in a sum to close a major transaction, before you agree consider how long it would take you to earn that amount of money after taxes.
Question 1: You are in Las Vegas for a weekend of gambling. This morning you won $1,000 playing the slot machines. Will you bet more tonight than you usually do? Question 2: You're in Las Vegas for a weekend of gambling. This morning you discovered that you have $1,000 more in your savings account than you thought. Will you bet more tonight than you usually do?
Perhaps not surprisingly, say Thaler and Eric Johnson, a marketing professor at the University of Pennsylvania's Wharton School, most people will take bigger risks with $1,000 won at a casino than with $1,000 of newfound savings. Gamblers even have a phrase for it: ''Playing with the house's money.'' This sort of ''mental accounting,'' as Thaler calls it, often gets us in trouble. ''We like to put money in categories,'' he says. ''But those categories tend to be too rigid.'' For example, say you need $15,000 to buy a car and have $15,000 in a money- market account earning 8%. Many people would leave those savings intact and borrow the money -- at a higher interest rate. Assuming a four-year loan at 12.5%, that would add almost $2,000 to their cost. ''They can't bear to dip into money they think of as savings,'' says Thaler, even to save money. Other mental labels, such as a ''windfall,'' have the reverse effect. Cheryl Ullyot, 41, a Northwest Airlines flight attendant, received $28,000 in back pay five years ago when the airline settled a class-action lawsuit with female employees. Most of it went to pay bills and provide a down payment on a home she bought with her husband. But she also invested $1,700 in Nationwide Legal Services, an over-the-counter stock she heard touted on television. Two years later, she sold the shares for $300. ''I would never have taken that risk if the money hadn't come from a windfall,'' Cheryl admits.
Mistake 7 We mentally pigeonhole money in ways that frequently don't make much sense. Advice: Use labeling tricks to your advantage. For example, before you invest or spend a windfall, park the money in a bank account for six months -- time enough for you to begin thinking of it as savings. Similarly, consider opening a payroll-deduction plan at work that will automatically channel income into investments -- a painless way to transform spendable ''pay'' into untouchable ''savings.''
1) Imagine that someone has just handed you $1,000. Now you must choose between these two options: Option A: You win $500 more for sure. Option B: You take an even chance of doubling that $1,000 or winning nothing more. 2) Imagine that someone has just handed you $2,000. Choose between two options: Option A: You lose $500 for sure. Option B: You take an even chance of losing $1,000 or losing nothing.
Kahneman and Tversky have found that in the first of these two situations, about 72% of people choose option A -- the sure gain. By contrast, in the second situation, only about 64% choose option A -- the sure loss. That's odd, since the consequences are identical. In both situations, the sure thing -- whether a gain or loss -- leaves you with $1,500. Likewise, each gamble offers an even chance of ending up with $1,000 or $2,000. Why the inconsistent answers? Among other things, our willingness to take a risk depends upon how we view our current situation. We tend to accept risk more readily when we see it as a chance to avoid a certain loss; therefore, we choose the second question's gamble to avoid the sure $500 loss. We are more conservative, however, when we consider opportunities to add to our financial gains; as a result, when we answer the first question, we take the sure $500 and refuse to gamble for the additional $1,000. Such confusion and bias often lead investors and entrepreneurs to accept risks that they should avoid. ''People will get themselves into a mess to avoid a sure loss,'' says psychologist Robyn Dawes at Carnegie Mellon, author of Rational Choice in an Uncertain World (Harcourt Brace Jovanovich, $14.95). For example, homeowners in a sluggish housing market will cling to a losing property even when further declines are likely. That's exactly what Marty Montefel, 55, a financial planner in Fort Lauderdale, and his wife Diana, 47, did when they moved out of their three-bedroom condo in 1985. Rather than sell at a loss, they rented it. Now their asking price is down to $50,000 (they paid $71,000 for the place in '82) and they're out $20,000 in maintenance and other costs. ''We should have tried to sell the condo when we first moved out,'' says a rueful Marty.
Mistake 8 Our tolerance for risk is highly inconsistent. Advice: When an investment performs poorly, don't hang on too long if there is a potential for further losses. On the other hand, if an investment posts gains, review the potential for additional profits before you decide to sell.
Consider what you would do in the following two situations: A: You win a $100 dinner with your spouse at a local restaurant next Friday night. Then a friend invites the two of you to his home for dinner the same evening. The other guest is a person you very much want to meet. Choose between the two dinners. B: You have paid $100 in advance to have dinner with your spouse at the local restaurant. The $100 is not refundable. Now you get the above invitation from your friend. Choose between the two dinners.
Most people find it hard to skip dinner at the restaurant in the second situation because they have already paid for it. But the $100 shouldn't affect their thinking, since they can't get it back. Instead, says Thaler, they should decide which dinner will give them more pleasure and choose that one. ''Future costs are what matter,'' says Baruch Fischhoff, a psychologist at Carnegie Mellon University. ''But often, people can't forget the money they've spent in the past.'' That pervasive problem offers a further explanation for our tendency to support lost causes. Kip Croskrey, 48, a mortgage broker in Portland, Ore., took a cold call last summer from a stockbroker who persuaded him to invest $23,000 in Comprehensive Care, a health-care company that trades on the New York Stock Exchange. The stock fell from $11.50 to $2.50 by last January, but Croskrey then shelled out $5,000 for additional shares, hoping to recoup his loss. ''The broker said it was a good idea,'' he says. ''Anyway, I had to make up the difference somehow.'' Croskrey was still stubbornly holding the shares in late April, despite having absorbed a total loss of about $17,500 on his investment of $28,000.
Mistake 9 We often throw good money after bad. Advice: Don't look back. ''Investors would make better decisions if they had no memory,'' says Schoemaker. ''Don't ask what you paid for a stock; instead ask yourself whether you'd buy it at today's price.''
Question 1. You have won a ticket to the sold-out Super Bowl. You very much want to attend. A stranger offers to buy your ticket. Name the smallest sum you would accept. Question 2: , You do not have a ticket to the sold-out Super Bowl. You very much want to attend. How much would you pay a stranger for a ticket?
Thaler finds that people demand an extravagantly high price for a ticket they already own but will spend less than half as much to buy one. Such discrepancies occur because we are well aware of out-of-pocket expenses -- in this case, what it would cost to see the game -- but ignore ''opportunity costs'' -- here, the money we would forgo by rejecting a good offer for the Super Bowl ticket. Such blurry thinking can be ruinous. For example, you might figure that it costs you nothing to turn down a chance to invest in your company's 40l(k) retirement plan. Think again. The annual opportunity cost of forgoing tax breaks and an employer's offer to match part of your investment can easily amount to more than $4,000 a year for a person earning a salary of $50,000.
Mistake 10 We frequently overlook opportunity costs. Advice: Before you spend or invest, consider at least half a dozen other uses for the money. Likewise, review your investments once or twice a year to be sure your assets are well deployed among available opportunities. ''If an investment isn't performing well, think about how you could use the proceeds from selling it,'' suggests the University of Arizona's Gregory Northcraft.
One last word of advice: Don't expect all of your decisions to be perfect. ''The secret is to understand your own motives when you make a decision,'' says Ellen Langer, professor of psychology at Harvard University and author of Mindfulness (Addison-Wesley, paperback $6.95). ''Then whatever happens, at least you can never call yourself a fool.''