Recently (here) I discussed two common mental mistakes. This month I thought I would add three more: a need to save face, improper extrapolation, and conscious weakness.
Saving Face. What I have termed “saving face” is an attempt to not feel stupid, or to avoid regret. People can go to elaborate lengths to feel they are smart and made good decisions. Here are some results of this need to avoid feeling foolish:
- An unwillingness to sell investments at a loss (selling before it “comes back” would be tantamount to admitting an error), or selling too quickly when investments go up (if it then went back down, the selling opportunity would have been missed). As we have explained in previous newsletters, research indicates the market is reasonably efficient – this means securities tend to be reasonably priced (except in hindsight!). Therefore, whether an investment is above or below the purchase price should be wholly irrelevant to selling decisions (except for tax consequences). Imagine a stock that was at $40 and Person A purchases it, then it declines to $20 and Person B purchases it and it is now at $30. Both investors should merely decide if the stock at $30 is likely to be a good investment for the future, and if so hold it, and if not sell it. However, Person A tends to hold it (sometimes forever, hoping to “get even”) while Person B tends to sell quickly (while he has the opportunity to feel good about his intelligence and foresight in making the purchase). This is an example of loss aversion.
- Taking risks to avoid perceived losses yet avoiding similar risks for similar gains. Here is a two question quiz to explain this. Answer truthfully!
- You are given $1,000. In addition to that thousand, you have an opportunity to choose an additional $500 or flip a coin – tails you get nothing, heads you get $1,000. Do you take the guaranteed $500 or the coin flip?
- You are given $2,000. However you now must either pay $500 or flip a coin – tails you lose $1,000, heads you lose nothing. Do you pay the $500 or flip the coin?
Most people would chose the guarantee in the first question and the coin flip for the second. This is mathematically irrational and occurs because of the way the questions were asked. Both questions are actually identical, and a rational person should either choose the guarantee in both, or the flip in both. (Notice in both questions the choice can be restated as $1,500 for sure or a 50/50 chance at $1,000 or $2,000.) Since the first question is phrased as going for a gain, people tend to be risk averse. Similarly, the second question is phrased as avoiding a loss so people tend to be risk-seeking in an attempt to avoid the loss. This is another example of loss aversion.
- Buying “popular” investments and avoiding “unpopular” ones. It appears people may value large, popular companies too highly, relative to the alternatives. We believe this is attributable to this same regret avoidance. If a large or popular (“growth”) company subsequently performs poorly the investor (or portfolio manager!) won’t feel foolish (or lose their job) because he or she had lots of company and no one could have seen the problem coming. Conversely if the same problems happened to a small or unpopular (“value”) company the investor would tend to feel foolish. For this reason, it appears small cap and value companies may be systematically underpriced.
Improper Extrapolation. We use this term to refer to mental mistakes people make in evaluating information:
- Overweighting recent data over long term data.
- Overweighting events that have a miniscule chance of happening (lottery tickets, a mutual fund averaging 20% a year going forward).
- Overweighting extreme events.
- Seeing patterns where they don’t exist (securities prices are widely accepted in academia to be primarily a “random walk with drift”, market forecasters notwithstanding).
- Changing frame of reference too slowly (e.g., as stock prices change, acting as though the “value” of the investment is still the old price). This is known to academics as “anchoring.”
- Believing a trend must reverse itself (sometimes inaccurately called “reversion to the mean”). This is known to academics as “gambler’s fallacy.”
- Placing undue weight on readily available information in a decision. This is known to academics as “availability bias.”
Conscious Weakness. People frequently make decisions that are irrational from an objective standpoint because they do not trust themselves and seek to restrain their own behavior. In these cases, they make decisions that are illogical to restrain their consumption:
- Inconsistent required rates of return. Examples include having too much withheld from taxes to get a big refund check as a form of “forced” savings; simultaneously having a college savings fund in a low yielding account and balances on high interest credit cards; or refusing to use a home equity loan to consolidate higher interest loans.
- Irrational spending rules. Never spending “principal” and consequently holding too much in bonds and ignoring inflation.
(That last category may not be a mistake in the sense that even though it’s not logically optimal it may be behaviorally optimal if it keeps someone from making a worse decision.)
Recognizing these tendencies toward illogical behavior and consciously avoiding them can improve your financial planning and help you reach your financial goals.