Why Smart People Make Big Money Mistakes--and How to Correct Them

Why Smart People Make Big Money Mistakes--and How to Correct Them

Lessons From the New Science of Behavioral Economics

Book - 1999
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Why do so many otherwise sensible people make foolish financial choices? Why do so many investors sell great stocks just before they skyrocket or cling tenaciously to lousy ones until they plummet? Why do some Americans overpay when they buy a house while others reap too little when they sell their home? And why are many shoppers willing to spend more for a product bought on credit than with cash? Indeed, whether in the stock market, the real estate market, or the supermarket, most of us keep making financial faux pas that cost us thousands of dollars every year.

Fortunately, many of the most common and costly money blunders we make can be explained -- and corrected -- by the new science of "behavioral economics." Gary Belsky, an award-winning journalist, and Thomas Gilovich, one of the leading experts in this burgeoning new area of research, reveal why people spend, invest, save, borrow, and, most important, waste money. They provide fascinating insights into all manner of occurrences --tipping, gambling, plane crashes, lotteries, and game shows, to name just a few -- to explain behavioral economics in a way that is as entertain

Publisher: New York, NY : Simon & Schuster, c1999
ISBN: 9780684844930
Characteristics: 220 p. ; 25 cm
Additional Contributors: Gilovich, Thomas


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Feb 16, 2018

They don’t understand risk

This is book does not explain well behavioral economics. That’s surprising given that one author studied with pioneers in the field: Daniel Kahneman, Amos Tversky, Richard Thaler, and Bob Frank.

Too often, the authors’ contradict themselves. In one section, loss aversion motivates people to sell out of stocks too early causing them to miss out on market rebound. In another section, loss aversion causes people to double up on their risk to erase losses. Thus, they associate loss aversion with both excessive risk avoidance and excessive risk taking. Which is it? This loss aversion conundrum is pervasive throughout the book.

Their semantic is often inaccurate. They repeatedly confuse “statistical regression” with “regression to the mean.” The former is a modeling technique, the latter is not.

The authors’ confuse complex situations with irrationality and their knowledge of statistics is questionable. For example, in one bucket 4 out of 5 balls (red portion 80%) you picked are red. In the second bucket 20 out of 30 balls you picked are red (red portion 66%). People consider that the first bucket has a greater proportion of red balls. The authors state this is the wrong answer, and that the second bucket will have proportionally more red balls because the larger sample provides more information. However, this is a tough statistical question that has nothing to do with irrationality. Also, the authors may have it wrong. The larger sample will narrow the confidence interval around their proportion of 66%. But, it will not increase the mean expected outcome from 66% to 80%.

The authors do not understand risk at all. As an example, drug A will not save 400 out of 600 terminally ill patients (but save 200 for certain); drug B has a 1/3 probability of saving all 600. The authors indicate that most people irrationally choose drug A. But, that is a rational choice. Drug A eliminates the risk of letting 200 patients die. Drug B has a 66.6% probability of letting 600 patients die. A probabilistic outcome is associated with a huge risk. Later in the book, the authors are incapable of differentiating the risk between rolling a dice and playing Russian roulette. They seem indifferent to either odds because they are identical.

Within chapter 6 on overconfidence they refer to another weak example. To stress that individual investors are overconfident they refer to an academic study that demonstrates the opposite. Indeed, within this study the average investor outperformed the market 17.7% to 17.1%. But, the authors make their case by focusing on the 20% of investors that generated the worse results and earned only 10%. But, they ignored the other 80% of investors who earned 20.9% return.

Within chapter 8, they criticize soccer goalkeepers for being irrational for picking a side when attempting to block penalty kicks. Instead, the authors advance the goalkeepers would be better off remaining in the center. Anyone who is familiar with the huge size of a soccer goal post has to question the judgment of the authors.

However, the authors’ recommendations are sound. Regarding investments, they recommend allocating a certain % to stocks for long term growth, diversifying your investments into different asset classes to withstand market downturns, and investing in index funds (better performance, lower cost and taxes). When buying insurance, they recommend you assume the highest deductible you can afford and self-insure all the risks you are comfortable assuming to save on premiums.

The two authors are poor teachers, but good personal finance advisors.


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