Posted on Friday, December 17, 2010
Certain money myths may be getting in the way of how you handle your personal finances. Does your financial belief system include any of these?
1. Procrastination. What 24-year-old hasn't thought, "Ewwww, retirement planning? BO-ring! I'm young -- I'll have plenty of time to get around to that." Thus, many an otherwise smart person has lost out on thousands or even hundreds of thousands of dollars in compounded interest they would have earned had they started saving in their 20s rather than in their 30s, or even 40s.
In a recent interview with the Journal of Financial Planning, behavioral economist and author of "Predictably Irrational" Dan Ariely pointed out: "Procrastination is about our difficulty acting for the long term, yet financial planning is all about the long term." When facing procrastination as an impediment to saving and retirement planning, Ariely suggests two solutions. First, calculate the opportunity costs -- the money you're losing by not getting on the stick. Any financial planner would be happy to help you do this, and investment websites abound with examples of how much interest you lose by starting your savings at age 35 rather than 25, for example.
Second, Ariely suggests that procrastination can be used in the procrastinator's favor. Rather than waiting to do a full-blown retirement or financial plan, just start saving as much as you can, now. Put off calculating the actual amount you think you need to save until later -- especially if you think it might be less than what you're actually saving. Then, if it takes you years to get around to reducing your savings, you'll be better off than if you had done the math upfront.
2. Overconfidence. When you think of overconfidence, the image that comes to mind might have more to do with the aggressive cheese-ball at the nightclub who thinks he's a ladies man than with money management. The real deal is that overconfidence is a fallacy with which financial planners and behavioral economists have long been concerned. When it comes to their finances, people are often overconfident in two important ways: They overestimate the returns their investments will get, and they underestimate the risk involved in their investments.
Need an example? Just think real estate, circa 2006. Much of our nation was swept up in both forms of financial overconfidence, in terms of the housing market: The sentiments that "It'll always go up" combined with the massive under-appreciation of the risk posed by taking on a short-term, adjustable rate mortgage for 100% of the home's current value are two of key factors that contributed to the current housing crisis now in its fourth year. (It's not only human beings that fall prey to these fallacies; banks clearly underestimated the risks of extending 100% mortgages to people who could document neither their income nor their assets.)
Correcting overconfidence is one role that a fee-based financial planner can play. But be careful not to fall victim to your money managers' own overconfidence: A 2006 study found that 74% of fund managers believed their performance was above average. Mathematically speaking, it's only possible for 50% of them to actually have had above-average performance.
3. The House Money Effect. The house money effect is a myth that causes people to be much more careless with money they received by any means other than their own hard work, whether it be stock market earnings, gambling or home appreciation. The old billboard which read: Your House is Not a Retirement Plan calls out one formerly common manifestation of the house money effect, wherein people expected to use their home equity as a windfall to fund their retirement. While some Americans certainly were able to sell their California homes and use the proceeds to live high on the hog in a small Texas town, I think we all know how this risky "retirement plan" turned out for the rest of us.
The house money effect also makes it more likely that you'll take one financial risk after you have closed out a previous risk at a profit. This is fallacious, since the risk is not lower just because lightning did not strike the last time you golfed in a storm. It's also related to overconfidence, as many investors who make money after a risky venture start to believe that their it was their own smarts that prevented them from taking a hit, which they believe may help them avoid the risk next time, too.It'
Overcoming the house money effect is critical for those making frequent stock trades and other major investment moves -- the more money you earn, the easier it is to take risks with it, as it may not feel like it's truly yours. Kenny Rogers said it best -- not only do you need to know when to hold 'em, to be smart with your money, you also need to know "when to fold 'em -- know when to walk away, and know when to run!"
4. Myopic Loss Aversion. If you suffer from the house money effect for long enough without managing or correcting it, you'll eventually end up losing money due to excessive risk-taking. Over time, behavioral economists find, myopic loss aversion, another financial fallacy, can actually correct the house money effect. Most of us feel the pain of losing money more intensely than the joy we feel when we earn or gain money and, as a result, will go to greater lengths to avoid losing than to gain. On top of that, because the human tendency is to do what we can to avoid losses, we also will check our investments frequently. If a watched pot never boils, neither does an overly-scrutinized investment, because myopic loss aversion may make the investor sell it as soon as we see it incurring losses, without taking the long-term view.
This same phenomenon takes place in the housing market. Forbes real estate columnist Stephane Fitch recently pointed out that housing is actually up 58% in value, over the last decade, despite the major glitches in home prices over the past four years. But rare is the guru who would loudly declaim that housing is a great investment, these days. In fact, many well-qualified, conservative would-be home-buyers -- afraid of losing a percent or two in the short-term -- are shying away from today's bargain basement real estate prices, losing out on the long-term investment value of real estate, in what may turn out to be the investment decision they most regret.
5. Attachment Bias. The best example of the attachment bias can be seen every week on PBS' Antiques Roadshow, one of my favorite shows. People scrounge up some tchotchke from their granny's neighbor's trash bin, drag it in and are clearly miffed when they're told it's only worth $1,000. The attachment bias causes people to value belongings more than what they would pay for that item if they didn't own it. It also makes them unwilling to sell things they own when they get an offer, because they are so certain that it's actually worth more than they are being offered.
Have you ever met a stubborn home seller? Nine times out of ten, they suffer from attachment bias -- virtually no offer is high enough. And if it is, it's still not, because if this buyer wants it that badly, someone else out there will surely want it even more!
Attachment bias also makes people hoard, and buy more stuff as soon as they get rid of some possessions. More belongings equal better, or so the attachment bias goes. Having to feed the monster of your unnecessary belongings, with time, work or even cash -- think: cleaning the home that's about 1,000 square feet bigger than your family really needs -- can cure the attachment bias pretty quickly. So can the desire not to lose more money on your home or other investments; a buyer's market can make even the most attached seller come to terms with what their home is truly worth.
When it comes to money matters, it can be very difficult to separate how your behaviors affect the outcome. Doing your research and being willing to correct your financial actions when the research suggests you should, staying open to the educated opinions of professional advisers and the money-savvy people in your life who have your best interests at heart, and constantly reminding yourself that things are just things -- that people and experiences are the ideal outlets for your emotional attachments, all can help you keep these traits from fouling up your financial future.Tara-Nicholle Nelson