How to Make Better Financial Decisions: Part 3

How to Make Better Financial Decisions: Part 3

May 30, 2024

financial decision-making part 3

How to Make Better Financial Decisions: Part 3

May 30, 2024

The Adverse Effect of Decision-Making Shortcuts

Daniel Kahneman passed away earlier this year. The professor of psychology won a Nobel Prize in economics for a lifetime of research on how humans make decisions, good and bad. I strongly recommend his book Thinking, Fast and Slow.

We are writing a series on his key findings to help you make better decisions.

  • Part 1 provided an overview of Kahneman’s research.
  • Part 2 focused on mistakes that prevent us from taking a longer-term view.

Daniel Kahneman found that often, we resort to decision-making shortcuts and biases that can lead to bad financial decisions. By understanding these biases, you can be better prepared to navigate the financial landscape and make more informed choices.

Loss Aversion

The pain of loss is much greater than the pleasure of gain. Here’s an example from a classic study. Someone is invited to bet on a single coin flip. If they lose, they will owe $100. How much must the win pay for the average person to want to bet? The answer: $250. In other words, the pain of losing is 2.5 times greater than the pleasure of winning. Economically, mathematically, or rationally, this is illogical. However, the study’s results have been confirmed time and again. Because of loss aversion:

  • People overpay for products like annuities that protect against loss.
  • They keep too much money in cash, even when it pays little or no interest.
  • They pay too much for insurance and select low deductibles even though higher deductibles usually make more sense.
  • They buy over-priced extended warranties.

Endowment Effect

We overvalue what we own, meaning we are less likely to sell something we should sell. This is true even for items of modest financial or emotional value. One classic study used coffee mugs and pens of equal (and minimal) value. A group of people received one or the other randomly. Few were willing to trade just minutes later without receiving a premium price for what was “theirs.”

Examples of how this can damage your financial plan:

  • Employees can have too much of their net worth in their company’s stock. We typically like our employer, and we believe in their stock. But having more than 5-10% of your investments in any one stock is a risk we don’t recommend.
  • Investors can be too reluctant to sell investments, especially winning investments. When a stock has done well, people ask, why not stick with it? The non-emotional answer – risk reduction – can be ignored by the emotional reaction of wanting to keep your winners.
  • Homeowners can expect a price that is too high when selling their home, which delays the sale, often for months.

Sunk Cost Fallacy

If we have invested a lot in something, it’s particularly hard to give it up—whether it’s a stock, a start-up business, or a relationship. With stocks: “I’ll wait until it gets back to the price I paid for it.” With a start-up business: “I’ll invest more, even though the company isn’t doing well because I have already put so much into it. I need to get my original investment back.”

Anchoring

Our first exposure to something can significantly influence our expectations. A common example is the used car salesman, who starts with a higher price (let’s assume $22,000) so that a $2,000 discount to $20,000 feels like a better deal than if you had walked in and paid an asking price of $20,000. In investing, we often anchor on what we paid and today’s price. Except for tax considerations, what we paid is irrelevant when we consider selling. Today’s price is relevant to judging our wealth today, but it may tell us little about where the stock will be in one or two years. Yet our go-to tactic in predicting the future is to start at today’s price and adjust from there.

 

Next week, we’ll provide a concrete example of how to fight against one of these biases: loss aversion.

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This article is not intended to provide tax, legal, accounting, financial, or professional advice. Readers should seek advice from qualified professionals who can review their specific circumstances. Old Peak Finance endeavors to provide information that is accurate and current. However, we cannot guarantee that this information has not been outdated or otherwise rendered incorrect by new research, legislation, or other changes. Old Peak Finance has no liability or responsibility to any individual or entity with respect to losses or damages caused or alleged to be caused, directly or indirectly, by the information contained on this website.

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