Why smart people make big money mistakes and how to correct themby Gary Belsky and Thomas Gilovich
This books is an interesting introduction on the subject of behavioral economics. The main idea is that many of our decisions as consumers and investors are not decided by reason, but through several mental processes that inhibit clear decision taking. Exemples of such processes are:
- mental accounting: thinking that dollars from different sources should be used differently. For example, money that you receive from gambling has not the same value as salary money. This explains, for example, why people that win the lottery can lose everything so easily.
- Loss avertion: people hate to lose money, and for this reason, they lose opportunities to make more money (since to make money we usually need to be exposed to more risk). Another example is the person that does not want to cut short his loses in some investment, since he has the hope that the investment will turn into profit. However, cutting loses early is the main technique to smart investment.
- Sunk cost fallacy: this has to do with the fact that people usually are attached to investments where they have put a lot of money, even if this will not bring any result in the future. The person does not recognize that the initial investment was a loss, and continues with the same failed strategy.
- Analysis paralisis: the tendency not to put into practice what is the most logical course of action.
- Endowment effect: the belief that a person is an expert in a field (especially financial investment) just because it has some basic knowledge. This explains why people tend for example to pick their own stocks, even when most professional in Wall Street are not able to beat the market. The main message here is: unless you are really a professional, invest only on index funds.
- Ignorance of math and probability: most of our financial problems come from the fact that we don't know enough math and probability to analyze the financial situations we encounter. For example, few people know the power of compound interests over investments. The main message here is: stocks look risky, but are in fact the most guaranteed investment on may do for the long term.
- Anchor bias: this is the tendency, when one is given any number, of being "anchored" at that number. For example, people overvalue products they want to sell based on a price that has no relation to the product.
- Herd investing: the well known behavior of investors of "going with the crowd". That is, buying when all are buying, and selling with everyone else.
This is an excelent book, since it gives clear explanations to many problems we face when managing not only money, but also our careers, our time, and our family.
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