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    Why Smart People Make Dumb Mistakes with Their Money
    Why Smart People Make Dumb Mistakes with Their Money
    Why Smart People Make Dumb Mistakes with Their Money
    Ebook154 pages2 hours

    Why Smart People Make Dumb Mistakes with Their Money

    By Kerry Johnson

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    About this ebook

    Why do investors constantly chase returns? Why do they buy mediocre investments that underperform the indexes? Why do they leave their money in investments that lose money yet are unwilling to sell until they increase in value? If you can understand your own behavior with money, you will become a much better investor and earn returns that will last your whole life. Now Kerry Johnson explains why investors (possibly your clients) make such poor decisions with their money.

    You will learn:
    • How overconfidence bias creates poor investment decisions.
    • How the endowment effect stops you from selling bad investments.
    • How sunk cost fallacy causes you to own investments until they are worthless.
    • How status quo bias makes change more difficult.
    • How framing and anchoring motivates you to spend more.
    • The seven steps in picking an outstanding financial advisor.
    • The five critical concepts in creating a successful portfolio.
    Kerry L. Johnson, MBA, Ph.D. , America's Business Psychologist, is a bestselling author and internationally sought after speaker with an upbeat, entertaining style, much like his writing. He travels 8,000 miles each week speaking around the world, and also heads a personal coaching company, Peak Performance Coaching.
    LanguageEnglish
    PublisherG&D Media
    Release dateOct 22, 2019
    ISBN9781722522964

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      Book preview

      Why Smart People Make Dumb Mistakes with Their Money - Kerry Johnson

      ONE

      Mental Accounting

      People who exhibit Mental Accounting rationalize that money won is in a different bucket than money earned. They can spend it differently and use it with more abandon. The truth is no matter how the money comes to you whether earned, given, or invested, it is worth the same. People tend to pigeonhole money into separate self-contained accounts and categories.

      I just won this money so I think I’ll just blow it all

      This allows them to be more risky or conservative, depending on where they put it.

      Once in a while, a financial advisor will outline to a prospective client their losses by using another broker.

      Sometimes the client will explain away the losses by saying, It’s all paper money anyway, suggesting it’s not real. This is a good example of Mental Accounting.

      People don’t really think they own or possess money unless it’s in a bank account or green in their pocket.

      Mental Accounting can be useful because it helps us treat savings for college and retirement as different buckets of money than the cash we use for casual spending. But it causes problems when you receive money from sources like salary, bonuses, gifts, or tax refunds. Those monies are spent differently and more quickly than money earned. I remember one client who had a savings account. They wouldn’t spend that sacrosanct money, no matter what the need. The money could be used for college, past due mortgages, or even a non life-threatening emergency. But they were so nervous they would run out of money, it became a type of lock box never to be opened, even in the direst of circumstances. Contrast this to another situation in which a client thinks whenever an account earns interest, it is their money to spend. If you feel the need to have mad money, just take 5% of your income and put it into a different account. This will help you spend money in an organized way instead of the money that burns a hole in your pocket when you feel rich.

      When Mental Accounting works, it keeps investors from raiding their retirement accounts to spend frivolously.

      Many did this with their home equity loans before the Great Recession of 2008. An example of this might be a 529 college education fund. You wouldn’t think of raiding a college account unless you were about to lose your house. After all, this is the bucket of money allowing your kids to go to college.

      I remember back in the 1970s when I was playing professional tennis, my mother gave me her VW camper van as a college graduation present. I was leaving for Europe for a couple of years, so I sold the van for $3,000 and put the money in a bank account in case I had a lean time on the tour. I wasn’t a world class player, so having a lean time was a probability.

      It wasn’t exactly Cortez’s burn the ships commitment, but at least I would have a cushion. This was my bucket of money allowing me to play tennis and get me through the weeks when I would lose in the first round. But apparently my mother thought the $3,000 was her own spendable bucket of money.

      After losing in the first round of three tournaments, I called my mom asking for the money to be wired to Germany. She didn’t have it anymore and apologized.

      As it turned out, this was the best thing for me. Just like Cortez, I had to either win or hitchhike and swim back to California from Europe. Of course I don’t fault my mom. She probably needed it more than me. But as a result, I became very resourceful and earned enough for the rest of my tour. There were no millions in winnings or endorsements, but I did make it from tournament to tournament.

      Let’s assume you had a ticket to the World Series, or at least a hard to get ticket to a show. At the venue, you realize the $250 ticket has disappeared. Would you buy another ticket using a credit card? Would you rationalize since you are already there, you might as well just spend the money for another ticket? Here’s another scenario for you. Let’s assume you reserved a ticket at the box office, but lost the $250 in cash on the way to the event. Would you be more likely to go home in this situation, or still spend the $250?

      Many people say they would cough up the $250 to replace the vanished ticket quicker than they would spend another $250 to cover the lost cash. Again, this is an example of Mental Accounting.

      Mental Accounting may also keep you from becoming wealthy. Many just can’t seem to save up enough to invest for retirement. They’re usually cost conscious when making large purchase like cars and houses. But when it comes to small purchases, they lose discipline. I was in Vail, Colorado recently and stopped to get gas for a rental car. As soon as I drove by the pump, I discovered gas was $0.30 more per gallon than at the station I just passed one exit earlier. I pulled away from the station and told my daughter it was too expensive and that I was going to drive back to the other station. She then said, What? Why are you trying to save only a dollar? But unless I’m spending a dollar to save a dollar, avoiding spending more than necessary will, in time, prevent that dollar from being invested. This is also a form of Mental Accounting.

      So if you spend a dollar or $100 several times a day rather than saving it, your investments will be impacted, and also, in time, the security of your retirement.

      If you give me a dollar, I will spend two

      You might be thinking, It depends on how wealthy you are! Yet the more money you have, the more likely you are to make these kinds of mistakes. It just occurs on a bigger scale.

      Marginal Propensity to Consume

      Economists call Marginal Propensity to Consume the theory explaining why some people cannot accumulate enough money to become wealthy or retire comfortably. Marginal Propensity to Consume (MPC) is defined as the percentage of an incremental dollar you spend rather than save. So if you receive a $200 tax refund and spend $160, your spending rate is 0.80 or 80%. But if all you do is spend money given to you, things may not be so bad. Many years ago, an economist at the Bank of Israel conducted a study of Israelis who were given restitution payments from the post-World War II Government of Germany. The money was intended to make up for Nazi atrocities against the Jews. But the payments could also be described as Mental Accounting found money to the recipients.

      The payments varied in size from family to family and individual to individual. The restitution was often equal to two-thirds of the recipient’s annual income.

      In this group, many had a spending rate of 23%. So that for every dollar received, 23% more was spent.

      But the group that received the smallest payments of about 7% had a spending rate of 200%. So for every dollar they received, they spent two dollars. You might say for every dollar of found money, they spent another dollar from income or savings. This happened to me when I played tennis in Europe. I just won the second round in St. Moritz, Switzerland, and made a whopping $150. I immediately put the money in the bank. But then one of the fans offered to pay me $100 for a one-hour lesson, sort of like $300 in today’s dollars. So that hundred dollars became found money. I took my friends and their girlfriends out for drinks at an expensive Swiss restaurant. As you might imagine, I spent $100 on drinks, but then another $100 on dinner rationalizing that it was a rare occasion that probably wouldn’t happen again. So my Marginal Propensity to Consume number was 2 (200%). If I had kept making that mistake throughout my life, it would be difficult to save any money at all.

      One of the best examples of Mental Accounting was a PBS special on how people save money. There were about six people in the group interviewed by a PBS host. At one point, the host asked how many owned savings accounts. She then asked how many also had credit card balances. I was shocked. Not only did all six have savings accounts, but they also admitted to credit card balances drawing an 18% interest rate. The host then asked one participant why she had a savings account in addition to credit card debt. She could just use the savings to pay off the credit card and avoid interest entirely. The guest replied she wanted to have an emergency fund in case something terrible happened. This is an example of how some people are tied to credit cards and often unable to get out of debt.

      You are a victim of Mental Accounting if you have emergency funds, yet still have credit card debt. You are a victim of Mental Accounting if you have trouble saving, but don’t think to recognize you are reckless spender. You are a victim of Mental Accounting if you’re more likely to spend a tax refund than funds from your savings account. You are a victim of Mental Accounting if you don’t look at money you invest with the same rigor as money you earn.

      One famous example of Mental Accounting is from research done by a behavioral economics researcher named Camerer in a study of New York City cab drivers.

      The cab drivers were paid a flat cab rental for 24 hours. Any money they earned would be profit after the fee. Each driver could decide how long or how little to work each day. One strategy would be to work longer on the good days, such as rain or convention days; or quit early on the bad days. What Camerer found was each cab driver set a target earnings amount for the good days. When they met that amount, the drivers would quit. When the bad days came, the drivers tended to work longer hours to make up for the limited earnings on the good days. This is totally irrational behavior. Yet

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