A brain
What’s that? You didn’t realize your brain is the enemy.
I didn’t either.
Once I realized this, it made life easier.
Why?
I was done working against my natural tendencies. I could now rewire my brain for financial success.
Below are 4 examples of financial mistakes which are natural tendencies of all humans. Also, how to prevent these mistakes.
Mistake # 1 – Mental Accounting
Definition: Tendency for man to divide money into separate accounts based on subjective criteria.
Typical Example: Treating a $100 you received as a gift from Grandma, differently than a $100 bill earned.
Typical Example # 2: Having money in a savings account earning .25%, with high-interest debt to pay off at 12%.
Cure: Funnel income, no matter the source, into one savings account.
Any “found money”, such as a tax refund or gift from Grandma, quickly decide where that money is best utilized.
As for expenses, occasionally change how you pay. If you always pay with a credit card, try cash.
Mistake # 2 – Price Anchoring
Definition: Man’s tendency to relate the value of a purchase to a price point that rationally should have no bearing on amount spent.
Typical Example: The “rule of thumb” to spend two months’ salary on an engagement ring.
Typical Example # 2: A Realtor will tell you that in 2007 this house was going for $500,000 and is now listed at only $350,000. Causing you to think this house is undervalued.
Cure: For big ticket purchases like a house, car, or engagement ring, ask a friend whose financial values you respect for their input.
For everyday purchases, avoid looking at the MSRP or sticker price.
Ask yourself:
- Can I afford this today?
- What do I really want to spend?
- What are some alternatives?
Mistake # 3 – Loss Aversion
Definition: Man’s tendency to avoid loss, rather than acquire gain.
Typical Example # 1: An investor is more likely to sell a stock that has increased in value, rather than selling stock that decreased. Overtime, his investment portfolio is made up of investments that have decreased.
Cure: Don’t think of selling a stock for less then you paid for as a loss. It’s a gain for two reasons:
- Tax deduction
- You can better utilize that money elsewhere
Don’t check your portfolio often. If you don’t know you’ve lost money, you don’t experience the pain.
Since stock prices go up in the long-run, the longer you go without looking at your portfolio, the greater chance of seeing a gain.
When trying to change a behavior, such as paying off debt, tell your 3 closest friends. Make a fake contract, sign your name at the bottom, and then email it to them. The pain you would incur from breaking that contract is high relative to the pain if you went about it alone.
Mistake # 4 – Herd Behavior
Definition: The tendency for man to want to do the same thing as a large group of other men, with no thought if that action is rational or irrational.
Typical Example # 1: Buying when prices are high because everyone else is.
Typical Example # 2: Selling when prices are low because everyone else is.
Cure: Warren Buffett said, “Be fearful when others are greedy and greedy when others are fearful.”
Keep this in mind when making your next financial decision. If everyone is telling you to buy this or buy that (i.e. gold, silver, real estate) do the opposite.
In the financial world, if it’s too good to be true, it usually is.
Also, write up an investment policy statement or contract.
Include factors such as:
- Investment objective
- Investment goals
- Desired asset allocation and diversification
- Summary of your risk tolerance
- Rebalancing schedule
Before making any changes, consult with this contract.
In the comments, have you made any of these mistakes? Please share along with how you’ve prevented from taking place a second time.
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Photo by: BlatantNews.com
{ 14 comments… read them below or add one }
I really identify with #1, and I definitely have made this mistake. I feel like it’s easy to fall into this because when my Grandma does give me $100, she’ll say something like “spend it on something fun!” That immediately sends my mind wandering towards what “fun” things I could spend it on. I’ll also add that I sometimes forget to account for the spending that I’ve already done with this new $100 and end up spending even more than the gift was in the first place! I agree that simply putting this into the same stream as your other income makes the most sense.
Great post and I really like the way you framed and detailed each mistake.
Thanks Jeffery. I’ve got myself in the same trap. That’s why I don’t mind receiving gift cards. (:
Great post RJ. I especially like #3 — we see it all the time that someone buys a stock or mutual fund and when it drops in value they’re committed to waiting until they are “back even” before selling, no matter how bad the prospects look for that stock/fund.
It’s important for people to understand that if you are going to invest, you owe it to yourself to invest in the best options you have available. Sometimes this means accepting that your decision didn’t work out, cutting your losses, and moving forward.
Joe @ blog.smart401k.com
Thanks Joe. I know from experience that’s a lot harder said than done. This mistake has cost me thousands of dollars. That’s never fun to admit but at least I know I won’t make it again.
Great advice on the notion that selling stocks for less than you bought in at is a loss. Can’t tell you how many times I didnt sell because I couldn’t accept a loss!
Thanks Dennis. Unfortunately, I’ve also learned the hard way.
I’m just glad I did now, with little money, rather than later in life when a lot more would be at stake.
Loss aversion is my biggest weakness!! It’s so hard to think that the money could hypothetically make a gain elsewhere. I instead tell myself that the money will CERTAINLY take a loss now if I sell it. If I hold it long enough, I reason, it’s sure to bounce back as long as the company doesn’t go bankrupt. Right?? (I can almost see you shaking your head no … but … but …. loss aversion is so hard to overcome!!) The tax benefit for the loss doesn’t apply to me, for a variety of complicated reasons.
Everyone, as I can being to tell through the comments and my own experience, struggles with this concept. It’s hard to look at the whole picture.
Great post. I like the last one and have been quite successful at buying stocks when everyone else is selling. A couple of years down the line I am the one who is laughing.
I usually do the funnel income, which I usually put everything into one savings account. But somebody advised me to have another account so that I could be able to rack which one is from my work or which one is from a sideline work. As for number 2, I was thinking of buying a ring but I am considering other alternatives to try before buying it.
If you do have two separate incomes, one from a side business and one from a regular job, than you should have two bank accounts.
My idea in this post, which you made me realize I didn’t emphasize enough was to take other earnings such as gifts or tax refunds and funnel them into one savings account. Don’t treat these earnings any differently, than you would earnings from a job.
Great post RJ. I love this point you made:
“Don’t think of selling a stock for less then you paid for as a loss.”
I’ve known about the tax deduction, but realizing you can put the money in a better place is a great perspective to have.
It took me a long time to realize this, but it’s so true. Thanks for the comment.
WONDERFUL post! When I do decide to splurge, I always make sure to establish the maximum amount I will spend. If whatever I purchase totals less than what I was willing to spend, I saved money. In addition, I rollover the remaining balance to add to my “splurge” account. Giving me more money to splurge for next time.
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