Thinking About

Why Smart People Make Big Money

Mistakes and How to Correct Them
A Commentary and Analysis















1st Edition May 2006

Copyright Daniel Appleman 2006
All rights reserved

Published by Daniel Appleman
www.ThinkingAboutMoney.com
Introduction
What does it mean to learn about money and finance?
To look at many web sites, the answer is simple learn to invest in mutual funds if not
stocks and bonds. Actually, let me rephrase for most web sites the answer is to invest in
whatever financial instrument or plan they happen to be selling.
Certainly learning about investment instruments has value, and I intend to be doing more
of that. But knowledge about investing is a small part of learning about money. And if
learning to make good investment choices is important, surely learning to avoid bad
investment mistakes is important as well.
Why Smart People Make Big Money Mistakes and How to Correct Them , by Gary
Belsky and Thomas Gilovich
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is about the science of behavioral finance. I found it a
fascinating read.
When you read this book, youll likely do as I did try to understand each of their points
and measure yourself against each one. It is with some slight degree of embarrassment
that I not only report here a brief summary of these mistakes, but also confess my own
standing on each one. Those are the places I need to focus on going forward.
Not all dollars are created Equal
The idea here is that in our minds, a dollar is not a dollar. For example: lets say you go
to the mall that new Harry Potter DVD just came out and you want it, but you really
dont want to spend the $20 on it, so you reluctantly walk away. Maybe youll buy it used
later.
But consider that on the way into the mall you found a $20 lying in a corner. When you
reach the video store you are much more likely to buy the video, because its found
money. In fact, youre much more likely to buy the DVD and a CD and a nice meal
effectively spending that $20 more than once.
Its the same $20 but its value is different in your mind.
Confession: Actually, this is one mistake I rarely make. Looking at the various examples
in the book, my sense is that for me $20 is $20 whether its in a bank account, cash in my
pocket, or invested in the market.
When Six of one Isnt Half A Dozen of Another
It turns out that for most of us the pain of losing $100 is about equal to the pleasure if
gaining $200. In other words, we will do more and take greater risks to avoid a loss, than
we will to achieve a gain.
This has a number of consequences. Basically they show that investors, as a class, tend to
sell winning stocks to early, and keep losing stocks too long.

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Published by Simon & Schuster, Copyright 1999
This is also the root of why we tend to throw good money after bad (called the sunk cost
fallacy) the idea being that youve invested too much in something to walk away from
it.
Confession: Guilty as charged. I have had a few cases where I have walked away from an
investment gone bad, and I think Im getting better at it. But I have a lot of work to do on
this score. I think there is a huge amount of pressure in the market to buy and hold. In
part this is good, because it helps avoid the mistake of selling in panic. But it does not
help us to cut our losses. Selling in panic, and failing to cut losses are both symptoms of
this mistake (though it seems contradictory, both are emotional rather than rational
responses to loss).
The Devil That You Know
This chapter examines how we deal with diversity. For example: the more choices you
have, the less likely you are to choose anything. It probably explains, in part, the success
of woot.com that simplifies its customers choices by providing only one product each
day. You can buy, or not buy if only all our decisions were that simple.
This may explain why so much money is stored in regular bank accounts there are just
too many investment choices out there.
It turns out we also strongly resist change. For example: if youre given $1000 cash for a
long term investment and have to decide between investing in stocks or putting it in a CD,
you might tend to invest it in stocks because of the expected long term returns. But if
youre given a $1000 CD and asked if you want to move it into the stock market, you are
much more likely to leave the money in the CD.
Not only do we resist change, we tend to place a higher value on things we already own.
Thats why businesses are so quick to offer money back guarantees and trial periods
once you have it or are subscribed to it, youre unlikely to send it back or take the steps to
unsubscribe.
Confession: While definitely not immune to this one, I dont see it as a huge problem in
my case. Probably in part a result of coming from the world of software development,
where change and diversity is forced upon us to an absurd degree. Making decisions
based on incomplete and imperfect data is a daily reality for me, as is filtering out a
subset of information on which to make those decisions, because you cant possibly
examine it all. In terms of investments, I definitely have funds misinvested, but I dont
think its so much aversion to change as not having time to figure out what I should do
with it. Part of this exercise is to gain the skills so that I can make wiser changes in the
months to come.
Number Numbness
Do you actually understand numbers? Think about it numbers are the essential tool for
thinking about money. Consider these examples:
If you invest $10,000 safely in a savings account earning 4%, After five years youll have
over $12,000 with no risk. Or is there no risk? If the inflation rate was 5% (not
impossible with the ongoing increase in energy costs) that $12,000 will only be worth
$9500 in terms of purchase power (real value). In other words, while we think of savings
accounts and CDs as safe, they are actually have quite a bit of risk.
What deductible do you carry on your homeowners insurance? If you could save
$100/year by raising the deductible from $500 to $1000, should you? The answer is
probably yes given that most people file a claim once every 10 years or so.
Oh, and by the way, you know those warning on mutual fund prospectuses that past
performance is no guarantee of future performance? Well guess what theyre right.
Most managed funds do worse than index funds, especially when considering their higher
expenses. It turns out that past performance of a fund has as much relationship to future
performance as one coin flip does over the next none at all.
Confession: Possibly the most important class I took in college was on Engineering
Economics. It basically taught that every engineering solution must take economics into
account, and to do so forced us through interminable calculations of future and present
value, rate of return, and so on. It had a lasting effect, because these kind of calculations
and this kind of thinking is routine for me.
Anchors Away
Youd like to think that in any decision you would weigh all the available facts and then
choose objectively.
But our minds dont work like that.
What actually happens is this you look at facts one by one until you find one that
swings you to one choice or another, and then weigh all subsequent facts by whether they
support or contradict that first preference. And youre much more likely to accept those
statements that support the preference than those that dismiss it!
This is called anchoring. We tend to fall in love with our ideas, and to be influences by
common knowledge.
Classic example: should you buy a house or rent? The answer is of course, to buy. Or is it?
Is it possible we are so anchored on the common knowledge that we dont actually
evaluate the choice objectively?
If you walk into a store, and see steak on sale for $8.99/pound down from $10.99/pound,
you dont think to wonder if maybe its $7.99/pound at the next market over. You
anchor on the $10.99 price and measure the cost from that point and it looks like a
good deal, even if todays $8.99 price is actually an increase from the non-sale price of
$8.49 from the week before.
Anchoring is one of the strongest traits there are, and among the hardest to overcome
especially in areas where you do not yet have much knowledge. An outside viewpoint
and checking your facts can help here.
Confession: Im about 50-50 on this one. I do think back on one time I was lucky enough
to avoid it. I was selling a condo and was planning to sell it myself for a price that was as
high as any condo in the complex had ever sold. I had anchored on that price, and
wanted to save on the commission. A very persistent realtor convinced me to sign on with
him both by offering his services in managing the cleanup and sales preparation, but also
by agreeing to list it for my price plus his commission (i.e., if he got the price, Id get the
same as I was originally planning). It was a perfect example of what the authors of this
book warn about anchoring on a number in an area where you dont know enough.
Fortunately, my realtor did not believe in anchors and did know his stuff. He ended up
netting me 15% more than I had wanted, even after the commission.
The Ego Trap
Possibly the most depressing chapter youll ever read. In a nutshell you arent as smart
as you think you are. No matter how smart you think you are, you arent. If you think
youre a good investor, you arent. If you think youre a poor investor, youre even worse
than you think you are.
Consider the fact that most mutual fund managers cant beat the market. Well, if they,
who spend all their time research stocks cant beat the market, why do you think you can?
Because again, youre overconfident.
The research that proves this is interesting, and may even be familiar. For example:
theres a survey in which 90% of drivers believe their driving skills are above average
In another example, it turns out that active stock traders historically do worse than those
who just buy mutual funds. In fact, the only valid investment approach is to buy index
funds, because while there are a few people who do consistently do well, you wont be
one of them.
Confession: While there is truth to this section, I think they miss the point. My initial
reason in starting thinkingaboutmoney.com was because I realized that I was not as
smart as I wanted to be, or perhaps not as smart as I thought I was. But it was also
premised on the idea that it is possible to become smarter.
To use the example of the driver survey, what does it mean when 90% of the drivers
believe they are above average? It means statistically that you are overconfident.
However, if you yourself have put in the effort to practice and study and improve your
driving skills, can you reach a point where stating you are an above average driver is a
virtually certain statement of fact? Obviously you can, because most other drivers will
not be doing that, so you will become a better driver than they are.
Am I wrong in believing that studying about money cant help one make better financial
choices, whether it is in life or business or investing? Answer: even if the premise of this
chapter is true, and we are all overconfident, then such study should nevertheless
improve our individual performance even if we remain overconfident. In other words, if
on a scale of one to ten, my investment skill is a 4 but I think it is a 6, and through study I
can increase my skill to a 6 but believe its an 8, Im still doing better than I was (unless,
of course, the overconfidence leads me to take stupid risks).
Quite a dilemma.
But heres the example in the chapter that really leads me to feel the authors have at least
partly missed the point. They note that 4 out of 5 businesses fail, and that this is a mark of
the overconfidence of those who start businesses. While its true that people starting
businesses tend to be confident, most of us arent stupid we know that 4 out of 5
businesses fail. But we also know that the potential rewards from the one business that
succeeds can be far greater than the cost of the four failures! So in fact, starting
businesses can be a very rational choice.
I Herd it Through the Grapevine
We all know the concept of peer pressure that we tend to follow the crowd. And it
doesnt take much research to convince me of the impact this has on investing By the
time you invest in a rapidly rising fund (following the crowd), chances are many of the
gains have been made. When you finally give up on a declining fund or stock, most of the
losses have occurred. The result is that many people sell low and buy high (the opposite
of what youd like to be doing).
Whats insightful about this chapter is its observation that in periods of uncertainty, or in
areas where you have less expertise, the trend to follow the herd is increased. Whats
more, as the impact of peer pressure grows, traders tend to overreact.
Which leads to this counter-intuitive result investors who listen to financial news tend
to do worse than those who dont! Acting, and overreacting, based on small and
sometimes irrelevant information resulted in poor decisions compared to those who just
sat back and based their decisions on their own research.
Confession: If youve been following www.ThinkingAboutMoney.com, it should be
obvious that on the scale of follower to contrarian, Im not only contrarian, but probably
closer to total skeptic (if not cynic). Why, I dont even accept the conclusions of the
authors of this book! There was a period, shortly after graduating college, that I really
paid attention to the stock market, watching the financial news shows and listening to the
talking heads. It didnt last long frankly, the whole thing seemed pretty silly. Thats one
reason that Ive been focusing on books rather than TV for this education process they
somehow seem more honest.
Conclusion
Over the years Ive intentionally tried to avoid learning about psychology, under the
principle that if I really knew how screwed up I was Id probably crawl into a corner in
my room and never come out. I cant say this book dissuaded me from that opinion.
Make no mistake, it was a good read. And I think understanding these tendencies in
myself (and others) is likely to help me do better in terms of my own investing if only
in that I can look at this behavior list before making a decision and at least try to evaluate
to what degree Im falling into a negative behavioral trap.
At the same time, while the authors do offer some hope that knowledge of these
behavioral issues can help you avoid some of them, the book really (and perhaps
unintentionally) has a rather pessimistic tone. I suppose thats an inevitable consequence
of its reliance on statistics. If 90% of the people behave stupidly, that means theres a
90% chance that youll behave stupidly, and no matter what you do or learn it wont
change that statistic (they call this sticking with the base rate when in doubt, always
believe the underlying odds).
As a result, their conclusion ultimately comes out to:
Start saving for retirement as early as possible
Invest in stock index funds
The fundamental question that is raised here is this:
If we know that 90% of the people invest stupidly, we also know that 10% of the people
invest wisely. Is it possible to educate yourself and move into the top 10%?
The simple statistical view would suggest that no matter how much you learn and
improve, chances are youll still be part of the 90%.
Another viewpoint is this: if 75% of money managers ( who presumably have gone to
school and studied this subject for years ) cant beat the market, what chance do you have?
The authors ultimate view seems to be that this book might help those who are foolish
enough to avoid their advice to stick with index funds, but it wont be enough to teach
them to beat the index funds.
Anchors Away Redux
I started this process, and www.thinkingaboutmoney.com on the premise that is possible
to educate oneself and move into the top 10% of investors. That would, in the terms of
the authors, be the anchor against which I am measuring the contents of this book.
So before just giving it up as a hopeless idea, there are a few other questions I must ask:
How hard is it really to learn to be a great investor? Is the fact that 75% of those
highly trained money managers cant beat the market an indication that investing
is hard, or is it possible they are learning the wrong things? Certainly this is a
field where there are many conflicting opinions seemingly more art than science.
One can become an above average driver with relatively little effort because most
people are not even trying. So it is in investing most people who invest do so
with little background or study. How hard is it then to beat the average?
Now, as the authors admit, an anchor isnt always a bad thing. So Im not quite ready to
accept their conclusions. I dont yet know what my investing strategy will become as this
process continues. I do know that the insights provided by this book are much more likely
to help than hurt. That said, I recommend it as a worthwhile, albeit sometimes depressing
read.
And besides, its already likely more than paid for itself, because I did follow up on their
suggestion to increase the deductible on my home insurance.

Why Smart People Make Big Money Mistakes and How To Correct
Them
by Gary Belsky and Thomas Gilovich