A recent Bloomberg article on behavior finance (“Manipulate Me: The Booming Business in Behavioral Finance”) shows how retailers and advisers use psychology to manipulate you and me into making irrational decisions on buying and selling things. Here are the main mental “traps” so you can take the first step in avoiding them.
- Anchoring: Attaching (or “anchoring”) our thoughts to a reference point despite the fact that there is no logical relevance to the decision at hand. (Your grandma always held her ATT stock, so should you!)
- Mental Accounting: Dividing your money into separate accounts based on criteria like the source and intent for the money, with the importance of the funds in each account also varying depending upon the money’s source. (You can’t spend even the interest and dividends from the money you inherit! Borrow money from me (at high rates) instead to meet your needs.)
- Confirmation Bias: We are more attentive towards new information that confirms our own preconceived options about a subject. We believe that, after the fact, the occurrence of an event was completely obvious. (I spilled coffee on the paper this morning, and I won the lottery; buy my coffee and you can win the lottery too!)
- The Gambler’s Fallacy: An incorrect interpretation of statistics where we believe the occurrence of a random independent event somehow causes another random independent event that is less likely to happen. (Enron has gone down three days in a row, you should buy now, as it is bound to come back today!)
- Herd Behavior: Our preference to mimic the behaviors or actions of a larger sized group. (Everyone is buying gold, why aren’t you?)
- Overconfidence: We overestimate our ability in performing some action/task. (If you have never lost money in poker, you can handle day trading.)
- Overreaction: We react to a piece of news in a way that is greater than the actual impact of the news. (Janet Yellin has a cold! Quick, buy these diamonds before the pending financial collapse!)
- Prospect Theory: We do not all have equal levels of joy and pain to the same effect. We are more loss sensitive in the sense that we feel more pain in receiving a loss compared to the amount of joy we feel from receiving an equal amount of gain. (Sell your house and use the money to buy this insurance, or know that your loved ones will suffer when you die or become disabled!)
The second step is to envision your futures, and the third is to model the scenarios that lead you towards where you want to go.