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What Was I Thinking?

4 minute read
Gary Belsky and Thomas Gilovich

Imagine you’re buying a mobile phone that retails for $100. At the store, you learn the same phone sells for $75 two blocks away. Do you walk to the other store? Now imagine you’re buying a ski jacket that sells for $800. At the shop, you learn the same coat goes for $775 at a branch two blocks away. Do you walk to that branch?

If you’re like most people, you answered yes to the first question but no to the second, even though both essentially ask if you would walk two blocks to save $25. Such differing responses are examples of mental accounting, a basic tenet of behavioral economics–a burgeoning field that explores human judgment in general and financial decisions in particular. Taking it as a given that people often behave irrationally, behavioral economists do their level best to understand how and why.

Mental accounting, while a godsend if it keeps you from blowing your savings, can also be costly–for example, when you are willing to spring for an optional feature when buying a car because, hey, what’s another $750 when you’re already spending $25,000? Worse, mental accounting is one of dozens of biases that, alone or in combination, wreak havoc on our finances. You could fill a book with these mental blind spots. We did, actually, and here are a few other common money blunders you’ll likely find familiar.

You’re too sensitive.

The granddaddy of all behavioral-economics principles is loss aversion, which earned Israeli psychologist Daniel Kahneman a 2002 Nobel Prize. His work with Amos Tversky in the 1970s demonstrated that most people respond to the loss of a given amount of money about twice as strongly as they react to a similar gain. Loss aversion is why many people routinely sell winning investments too quickly and hold losers longer than they should. The pain of making a loss final by unloading shares outweighs the rational reasons for dumping them. Loss aversion is likewise partly to blame when employees can’t convince themselves that they should contribute to 401(k) and other retirement accounts–often missing out on employer matches–because a painful drop in today’s spending power overrides the pleasure of tomorrow’s spending gains.

You’re easily distracted.

As we’ve seen recently, many investors have no problem whatsoever selling losing stocks. In fact, they tend to sell both winners and losers when share prices start crashing–even if they don’t need their funds for decades. Two related biases are at work: availability, which refers to our tendency to make decisions on the basis of information that comes most easily to mind, and recency, which describes our habit of giving too much significance to the latest events. An awareness of these biases is why rich old codgers buy shares for their grandkids when stock prices plummet; they recognize what are actually buying opportunities, because they’ve seen such slides before. On the flip side, insurance buyers who fall prey to these mental missteps often keep their deductibles too low: news reports about this natural disaster or that crime spree lead us to overestimate the likelihood that a tree will fall on our house or our car will be stolen.

You can’t let go.

Lawyers typically rank low on job-satisfaction surveys, but ask an attorney why she doesn’t switch careers and she’ll probably respond with a pair of numbers: how long she’s been practicing and how much law school cost. The sunk-cost fallacy refers to the unconscious desire to have our current choices justify prior decisions. It’s the reason many car owners continue to repair a lemon–because they can’t bear to give up on the money they’ve already spent–and it helps explain (with loss aversion) why so many homeowners resist selling when real estate prices tumble, only to unload their houses for even less just a few months later. Sometimes the best strategy is to cut your losses and run.

Belsky and Gilovich, who write for TIME.com’s Moneyland site, are the authors of Why Smart People Make Big Money Mistakes–and How to Correct Them

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