Background: One of the books on psychological pitfalls that I've been meaning to read. Charlie Munger has written some good stuff on psychological traps and also introduced me to some excellent material by Robert Cialdini.
Key pitfalls highlighted in the book:
- Assigning different value to money due to "mental compartmentalization". For example, viewing money from one-time gifts, casino gains, tax refunds, etc. as "cheap", new-found money, and having more tendency to spend them; while viewing money in retirement accounts, inheritences, etc. as "expensive", untouchable money, resulting in being overly-conservative.
- Viewing gains and losses differently. When considering gains, people want to gain at least "something", and don't like the possibility of "not gaining anything". Hence assume you start off with $1000, with Option A: Get $500, Option B: Get $1000 or $0 with 50-50 chance. Most people would choose Option A. On the other hand, when considering losses, people "don't want to lose anything", and don't like any "sure losses". So much so that they are willing to take on more risk so as to have the chance of "not losing anything". Hence assume you start off with $2000, with Option A: Lose $500, Option B: Lose $1000 or $0 with 50-50 chance. Most people would choose Option B. Note now that the end state of both scenarios are the same. Hence the angle from which you view the problem is important. This pitfall also explains why people tend to sell winners (and capture the gain), while holding on to losers in hopes of a rebound. For me, I would think that most situations in life should be viewed from the "gain" angle – errors of ommision are less "impactful".
- Being influenced by sunk costs. People are typically influenced by sunk costs, e.g. a person having spent $350 on a theatre ticket, will almost certainly attend, even though he knows its an extremely lousy show and he made a mistake in purchasing the ticket in the first place. Or, having spent $2.5 million on a project, will spend more money to complete the project even though it has been recognised as a lousy project.
- Ignoring "small" numbers. Small numbers, e.g. incremental expenditures, daily expenditures, brokerage commisions, mutual fund expenses, inflation, etc. adds up to big costs. Thinking them as "insignificant" results in you paying more of these small costs, snowballing into large costs.
- "Anchoring" onto irrelevant numbers. People tend to anchor on irrelevant numbers, thereby skewing their judgment/estimates. E.g. after a stock has dropped from $40 to $22, people "anchor" on the $40 and think that $22 is a great bargain. Or buying a house at $300,000 during a housing market boom and wanting to sell it at close to $300,000 during a market downturn.
- Overconfidence in your own abilities and knowledge. A 1981 survey of drivers in Sweden have 90% of them describing themselves as above average drivers. PhD students always underestimate the time they require to complete their thesis. Project managers always underestimate the budget and time required for the projects. Investors always overestimate their ability to pick stocks (also due to the Commitment and Consistency principle from Cialdini).
- Unwillingness to admit mistakes. "If the stock goes up, I'm a great stock picker. If the stock goes down, its the market's fault and beyond my control".
- Following the herd. e.g. buying into a stock/fund because it has run up, dumping a stock/fund because everyone else is selling.
- Knowing too much. Having too much information increases the chances of anchoring onto irrelevant/unimportant information and taking actions that increases the chances committing mistakes.
- Not knowing the "base rate". 70% of mutual funds underperform the market. Funds that have outperformed the market tend to underperform in the next period, and vice versa. Would a quiet, studious person more likely be a librarian or a salesman? What if I tell you that there are only 100,000 librarians in the country and 1.5 million salesmen?
Despite all the financial pitfalls above, the authors gave a good warning: "Trying to extract every last dime out of your financial decisions is likely to incur significant social and psychic costs."
Summary: I like many of the examples given in the book, but more often that not, I disagree with the explanations. I think the principles given by Robert Cialdini would be more suitably applied in explaining many of the examples.