Why Smart People Make Big Money Mistakes
...and How to Correct Them

Authors:   Gary Belsky & Thomas Gilovich
Publisher/Date:   Simon & Schuster (1999, 2009)
ISBN:   978-1-4391-6336-8 (Paperback, 275 pages)
Related Post:   5 Reasons to Read: Why Smart People...

If there's another book out there which addresses the topic of behavioral finance as it relates to everyday consumers and the money decisions they make, AND manages to keep the discussion on a level suitable for folks who don't have a Ph.D. in economics, then I haven't found it. On my list, Why Smart People Make Big Money Mistakes (hereafter referred to as "WSPMBMM") stands alone as fitting that bill.

While the book has become a favorite in stock-market trader circles (a decent portion of the work is devoted to the psychological reasons behind "common investor mistakes"), the majority of its content would be a beneficial read for anyone who (1) makes money, and (2) spends money.

The back cover labels WSPMBMM "...a fascinating investigation of the ways we spend, invest, save, borrow, and waste money." And in most places, the book is pretty fascinating. There are a few occasions wherein the authors (Belsky is an award-winning business journalist, and Gilovich a professor of psychology at Cornell University) spend an overly noticeable amount of time detailing and critiquing the studies put forth by previous researchers in the field of behavioral finance. On the whole, though, it's a well-written venture.

Each chapter is laden with scads of details about these previous economic "experiments" — which usually involve coming up with "Suppose you encountered this financial situation; what would you do?" questionnaires and foisting them upon unsuspecting groups of college students. Broad-based conclusions were then drawn from the surveys. (In real life, I imagine these findings lead to lots of professorial back-patting, followed by the obligatory 40-page write-up being published in the Journal of Unintelligible Contemporary Financial Theorems.)

Following is an example of just such an "experiment" as it was related in WSPMBMM.

Consider an experiment conducted several years ago by Drazen Prelec and Duncan Simester, marketing professors at the Massachusetts Institute of Technology in Cambridge, Massachusetts. The pair organized a real-life, sealed-bid auction for tickets to a Boston Celtics game (this was during the Larry Bird, Kevin McHale, Robert Parrish era, so the tickets were especially valuable). Half the participants in the auction were informed that whoever won the bidding would have to pay for the tickets in cash (although they had one day to come up with the funds). The other half were told that the winning bidder would have to pay by credit card. Prelec and Simester then averaged the bids of those who thought they would have to pay by cash and those who thought they would have to pay by credit card. Incredibly, the average credit card bid was roughly twice as large as the average cash bid. Simply because they were dealing with plastic — with money that was devalued in some way — the students became spendthrifts. Put another way, credit cards turn us into big spenders in more ways than one. We become poorer because we're more likely to spend, and more likely to spend poorly.

Reading that, did you get the feeling (as I did) that you were listening to a narrator on a Discovery channel documentary? That's the tone the authors undertake in the entire book, and I think it works well. (In their introduction, in fact, the authors write that they want the book's tone to resemble "...a conversation at a cocktail party.") Honestly, I applaud that goal. If you've ever troubled yourself to read an economic- or behavioral-finance-related paper published by any of the stuffy academic journals out there, then you'd understand why I'm happy that someone took the time to write a book that makes this stuff accessible to the rest of us.

Here's another passage, this from the chapter on anchoring. This paragraph, for me, brought about one of those "Sheesh, why didn't I notice that before?" moments. (For what it's worth, I had a lot of those moments in this book.)

Have you ever been married or engaged or considered either? How much do you think a diamond engagement ring should cost? For many of you, the answer is "two months' salary." That's the "rule of thumb" most people use for answering that question, a rule promoted by the diamond industry in ad campaigns and informational material. It's a completely ridiculous figure — a ring should cost no more than you can afford! But it has become a standard point of reference for engagement ring purchases. Diamond merchants, you see, understand that by leading people to start with a dollar figure equal to two months' salary, they almost certainly guarantee more money for their industry. Why's that? Because people who might have spent less for a ring will have been programmed to think that two months' pay is the point below which they're being a cheapskate (and what man wants his financée to think that?). They'll anchor on the equivalent dollar figure if they don't know that this is happening — or even if they do. Meanwhile people who would likely spend more than two months' salary will do so anyway — they'll assume that the benchmark is for people who don't have as much money as they do or don't love their financées as much.

Rather than attempt to summarize many more of the book's themes, I'll take the easy way out and simply show you the Table of Contents, along with the authors' descriptions of each chapter. They do a finer job of conveying the info than I could. And don't let the econo-psycho-babble terms scare you off; by the time you've finished each chapter, you'll be on top of all of it ... and it won't even have been that hard.

How "mental accounting" can help you save ... or cost you money.

How "loss aversion" and the "sunk cost fallacy" lead you to throw good money after bad.

How the "status quo bias" and the "endowment affect" make financial choices difficult.

"Money illusion," "bigness bias," and other ways that ignorance about math and probabilities can hurt you.

Why "anchoring" and "confirmation bias" lead you to make important money decisions based on unimportant information.

Chapter 6: THE EGO TRAP
"Overconfidence" and the price of thinking that you know more than you do.

"Information cascades" and the danger of relying too much on the financial moves of others.

Conclusion: NOW WHAT?
Principles to ponder and steps to take.

As often happens with me, I found WSPMBMM to be much better on the second reading. If you're interested in delving a bit into the psychological side of money, spending, and the nonsensical financial mishaps we all make from time to time, then this is likely going to be a worthwhile book for you.

Michael • May, 2003

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