MONEY MISTAKES

AIM

Evaluate biases in financial Decision making and study why do immensely smart people make so many money
mistakes in the life?

Background

One of the first assumptions of traditional economic theory is that humans are rational creatures and will make a
choice which maximizes value. Simple observation of human behavior will prove otherwise and nowhere is it more
visible than in financial decision making. Most of financial decision we make tend to be based on our emotions
rather than logical reasoning

In so many instances if I have to pay money using a credit card I tend to buy things which I don’t need .Suppose I
had to pay cash to buy the same thing I will not buy it. For people credit card is not real cash. Buying something
which you don’t need using cash you don’t have is simple bad decision making.

Suppose you are with car dealer wanting to buy a car for $40000 and salesman tell that if you go to the branch down
town you get a discount of $100.Most of us wouldn’t bother to commute so much just to get a discount of $100.But
suppose you were buying a watch for $400 and I tell you that you get a discount of $100 if you go downtown most
of us will take that discount. Though the amount is the same but the reference point differs.

America went through a financial crisis in 2008.The crisis was brought about by seemingly smart people who
studied in the best schools in the world. How come they could not anticipate what was coming next? The whole
premise of the crisis was that house prices don’t fall .People were sold mortgages whose interest payment they could
not afford leave principal out. Most of people who bought this overpriced house didn’t have any income or assets to
support their purchases. But so long as house prices were rising no one really cared. These mortgages were
packaged and resold to gullible investors who didn’t realize the risks involved in these securities. Fear and Greed are
two very important human emotions which tends to blur rational and logical reasoning

We tend to use different mental accounting in our mind .Suppose if I find $100 on the street I would buy a expensive
gadget for myself though I would not buy the same gadget from my salary. Both the dollar bills are the same but our
mind doesn’t think that way.
When buying stocks people try to enter the marker when their friends and neighbors are buying stocks though most
probably this won’t be the ideal time to buy as prices have already peaked but greed takes over and people lose
money. It doesn’t matter to them that they are no idea about the business model of the company. Who are its
customers? What products does the company make? Who are its competitors? Does it have any strategic competitive
advantage or not. How much debt does it carry on its balance sheet? Is the management honest and reliable? Does
management care about the minority shareholders or not.

Normally the best time to buy stocks is when no one seems to be interested in it. Prices are reasonable and you have
good margin so safety .But people’s emotions take over .After losing money once they tend to shy away from the
market for the fear that they might lose money again. They wait for others to buy and once they see a lot of buying
interest they also buy. Rather than having odds in their favor people buy when the odds are completely against it.
Why does the human mind react like this? We all like to buy the in things the stuff that is in demand. The mutual
fund which earned the most money this year though we fail to take into consideration that everything reverts back to
the mean

The fear of losing money is greater than the happiness of gaining money. Most people would sell the stock in which
they are gaining money and hold stocks in which they are losing money. More specifically, a loss has about two and
a half times the impact of a gain of the same size. So we like to be right and hence often seek high-probability events
But do we consider the probabability and payoff to calculate the expected value to reach to a conclusion. I doubt
many people would do that. What we rely is our emotions or gut feeling as people call it.

If you don’t have the time or inclination to learn about companies the best thing would be to invest in a index fund.
But people try to invest on their own assuming they can beat the market. The odds of winning in the market are
completely stacked against you .But somehow people think they can beat the best money managers in the world. We
like to be in control .It’s gives us a feeling of importance .How many of us are scared flying in a plane instead of
driving a car when it is known that’s the odds of dying in car accident is many times more than dying in a plane
crash. Driving a car gives us a feeling of control which we don’t get when we are flying in an airplane

Retirement planning is one of important tasks we all have to go in life .But we take two months to plan a vacation
but cannot spend even a week to plan our financial future. We relax and procrastinate and wait for things to get out
of hand. People who overspend try not to check their account balance for the fear or not liking what they might see.
Study was conducted by a team of researchers from Stanford University, Carnegie Mellon University, and the
University of Iowa, related to people making investment decisions unable to feel human emotions and people are
who are able to feel human emotions. Each group was given $20 and had a option of betting $1 on the flip of a coin
those who said no kept their money and those who said yes have a option of winning $2.5 if they get the call right
.Since you have 50 % chance of getting the call right and they payoff seems to be better if you get the call right
.Rationally it makes a lot of sense to play the game. People who could not feel emotions played most of the round
whereas people who felt emotion walked pretty soon though it was in their favor to pay the game. Even long term
investors who would be better off if they invest in equities tend to shift to bonds when they see the market in a down
turn.

After making bad investments it would very rational for people to analyze what went wrong, what mistakes were
committed so that we don’t repeat the same mistakes again .But analyzing losing investments makes us sad. It brings
in a feeling so pain which we like to avoid. So we keep making the same mistakes again and again so as not to get
that feeling.

People buy bonds even though it doesn’t beat inflation in the long run. They feel it is safe since the principal is
protected. What they don’t realize is that even the principal is losing money due to long term price rise. A dollar
today won’t be the same as the dollar ten years from now. If interest rise sharply bonds prices will fall.

I remember planning to buy a stock when it was at $20 but didn’t have the money to so. I knew that the company
had excellent business prospects .When I finally had the money to buy the stock it had doubled. I waited for the
stock to come to my reference point but it never came. The fundamentals of the company improved and I was left
with nothing but regret. Once people anchor to a certain price point it is very difficult for them to move from the
price they have in their mind. One of my friends wanted to sell his house for a certain amount and found a willing
buyer for it. Unfortunately the housing market crashed and my friend is still waiting to sell his house at a previous
price point even though there are many houses in the neighborhood which are much better than the house my friend
is willing to sell at and at a much better price. People tend to stick to a price they have in their mind and it’s very
difficult for them to move from that price
People like to invest in things they don’t know rather than investing in stuff that lies in their circle of
competence.Poeple who work in IT invest in pharmaceutical and vice versa. Why would rational people do
that.Wouldnt you stick with something which you know rather than speculating things which you do not know. They
would readily pay a doctor for diagnosis but would shy away for paying a mutual fund manager.Wouldnt we are
better off if we let a specialist do his job rather than doing it half heartedly ourselves. But human emotions take over
and rational thinking is left behind.

People are over confident about their abilities. If you ask them what is the capital of Congo and give them options
they would pick and answer. The surprising part is how confident they are with the answer most of them said they
were 90 percent confident that their answer is right. Unless and until you have majored in geography it would be
very difficult for you to get the answer right. We normally over estimate our abilities and don’t the necessary
knowledge to make an informed decision. The same way buy securities again and again thinking that they have
superior intellectual without realizing that they were losing a lot of money by the way of brokerage fee. People are
over confident because they like to remember all their successes and forget all their failures. When you win you
think it’s because of our abilities whereas when you lose you think it is someone else’s mistake. May be the
economy is bad, fiscal deficit is the problem, interest rate is high and you are not responsible for any of these. Why
do humans do that? Over confidence will cost you if take make big money decisions without researching. Become
happy with winning stocks but ignore the losing stocks. You thing selling your house without a broker is a good
thing when in reality you have no idea how to sell your house. When does over confidence help us .Over confidence
helps us to start new businesses, explore new areas, innovate and research .If we knew the limits of our capabilities
we would be very depressed and never try anything new. The world will be bereft of any new innovation,
discoveries etc.

Sitting in one restaurant in a posh place I was going through the menu. There were two soups with nearly the same
name. But one at least was $10 cheaper than the other one. I thought I got a bargain and ordered the cheaper. After
some days I met friends who use to work as the financial analyst for the company running the restaurant .I told him
about this anamoly.What he told me astonished me a lot. Their aim was not to sell the expensive soup but act as a
reference point for people to compare. And people always fell for the trap buying the cheaper soup. Our brain
always looks at two identical items and compares its price point. If one item is cheaper than the other one we assume
that it is cheaper than the other one.

I remember a friend who got a hefty bonus in an investment bank .He was pretty delighted with it till the time he
came to know that his colleague had received a higher larger bonus. After this his joy turned to disappointed. Why
do we always compare ourselves to others.Isnt we suppose to get bonus according to our performance. Rationally it
is proper but emotionally our mind doesn’t accept this.
Have you ever been to a supermarket and saw a sign of FREE? Whenever we see something like one for one is free
we would buy something we wouldn’t have bought. It’s just getting something for nothing makes us so happy to
plunge into making a decision .There is nothing like a free lunch. And if something is free it might hidden charges
that are attached to it. Would we have bought a product if both were at a fifty percent discount? Not probably but
getting something for free has changed our mind. I remember a particular scheme by Amazon that we bought a book
we had to pay shipping charges for $3 .But suppose we buy two books they were no shipping charges. Most people
didn’t want the second book but they still bought it just to get something free.

It’s very hard to accept mistakes. If suppose with high conviction you bought a stock it falls down due to
deteriorating economic fundamentals it’s very hard for you to sell it .It’s very important that you evaluate every
investment on the basis of economic fundamentals rather getting married to a stock.

CONCLUSION

To conclude human emotions play a very important part in financial decision making and most of the time the
financial decisions we take are not in our best interest

WORK CITED

Mauboussin, Michael J., 1964–

More than you know: finding financial wisdom in unconventional places

Ackert, Lucy F., and Bryan K. Church. 2001. The effects

of subject pool and design experience on rationality in
Experimental asset markets. Journal of Psychology and
Financial Markets 2, no. 1:6–28.

Goleman, Daniel. 1995. Emotional intelligence. New

York: Bantam.

Isen, Alice M. 1999. Positive affect. In Handbook of cognition

and emotion, edited by Tim Dagleish and Mick
Power. New York: John Wiley and Sons.