"Why Smart People Make Big Money Mistakes and How to Correct Them" by Gary Belsky and Thomas Gilovich was a book first published in 1999. I've never heard about the book before but one of the teachers in a finance course I took recommended it. I didn't expect too much from the book because it was published more than 10 years ago but guess what? The book's content is still very much relevant to modern times and I've to say it's the best personal finance book I've ever read.
The book is not your usual personal finance book that tells you how to do a budget or save money. Rather, the book tackles behavioural finance and economics which makes you better understand your attitude towards money. And these are behavioural tendencies that we're guilty of doing but are not conscious we're doing them. That's why it's important to know them so we don't make as many, and worse, costly mistakes.
Here's a summary of important learnings from the book - there are a lot more but I just handpicked some. Text in italics are excerpts from the book.
- We have a tendency to treat money differently depending on where it comes from, where it’s kept, or how it’s spent. If we earn money through gifts, bonuses or prize, we have a tendency to spend it mindlessly or impulsively. We've to learn how to view money equally whether it's salary, bonus, winnings or gift. A USD100 earned from work has the same buying power as a USD100 given as a prize.
- We are generally loss averse. The pain we feel from losing USD100 is much greater than the pleasure we'll experience from gaining USD100. This prevents us from taking risks.
- We suffer from the sunk cost fallacy. Spent money doesn't seem to matter anymore. For example, you wanted to buy a good stereo but learned that it costs USD1,000 and it doesn't make sense to you since your car is old. But the following year, you buy a new car and wanted to upgrade its stereo. The car dealer quotes you USD2,000 and you agree because USD2,000 relative to the total price of the new car looks like a fraction.
- We tend to be overconfident and overestimate our knowledge and abilities. With a little knowledge or homework, we think we can pick investments with better-than-average success. Another good example of this is when we are lured to signing up for gym memberships. We sign up long-term contracts overconfident that we would be able to frequent the gym but chances are, we are never able to maximize our memberships and paying per workout turns out to be cheaper in the long-run.
- We tend to base our decisions on the actions of others. We sell when others sell. We buy when others buy.
- Too much info can be destructive. Studies have shown that investors who tune out the majority of financial news fare better than those who subject themselves to an endless stream of information, much of it meaningless. Similarly, the less frequently you check on your investments, the less likely you’ll be to react emotionally to the natural ups and downs of the securities markets. For most investors, a yearly review of your portfolio is frequent enough.
- Switch to index funds. This mirrors the benchmark stock and bond averages in different investment categories. The idea is to guarantee that you will at least keep up with the typical investor – but in fact, you’ll likely do better than all those brave souls who think they can beat the law of averages.
- Diversify your investments. Most investors who are still working should have a large portion of their assets invested in the stock market, which has historically offered the best returns over time.
- How much do you need to invest in stocks? There's the “100 minus your age rule” - if you’re 30 yrs old, about 70 percent of your long-term nest egg (100 – 30 = 70) should be invested in stocks (the book suggests index mutual funds).
- Forget the past. Very often our decisions about the future are weighed down by our actions of the past. People stay in unsatisfying careers because of the time and money they invested in school, not because they enjoy the work or expect to in the future; we finish a bad book because we’ve already gotten so far, not because we’re anxious to see how the characters live; we sit through a boring movie because we bought the ticket, not because it’s a good flick. The same motivations affect our decisions about money: We spend more money on car repairs because we’ve already spent so much on the car; we keep spending money on tennis lessons because we’ve already spent so much. We hold on to bad investments because we can’t get over how much we paid for them and can’t bear to make that bad investment “final.”
