Why Smart People Make Big Money Mistakes

Gary Belsky & Thomas Gilvoich, “Why Smart People Make Big Money Mistakes—and How to Correct them: Lessons from the new science of Behavioral Economics”, Simon & Schuster, 1999, 220 Pages (Paperback).

This is a very good book explaining concepts in the relatively new field called behavioral finance or behavioral economics. Even though it was written in 1999, its’ concepts are every bit as valid now as then. The premise behind the book is that individuals can learn from their mistakes. By identifying and understanding your behavioral-economic shortcomings, you can correct them and enjoy more financial freedom. Some of the 1999 warnings, particularly on housing prices, are worth noting. The authors, (Belsky is an award-winning business journalist, and Gilovich a professor of psychology at Cornell University) have put together an easy to read book for anyone who makes money and anyone who spends it. This book spends a good amount of its’ time detailing and critiquing the studies put forth by previous researchers in the field of behavioral finance.

My notes:
Pg. 14: Behavioral economics combines the twin disciplines of psychology and economics to explain why and how people make seemingly irrational or illogical decisions when they spend, invest, save, and borrow money.

Pg. 17: Traditional economic theory mistakenly posits that the decisions we make are because of a consistent and rational pursuit of satisfaction and personal fulfillment, of getting the most out of life with our current and future resources.

Pg. 33: Mental Accounting: refers to the inclination to categorize and treat money differently depending on where it comes from, where it is kept, or how it is spent. For instance: imagine walking into a casino and plopping $100 down on one number at 32:1 odds, and the number hits. The winnings will be treated as “house” money. You will probably bet much more at all the games that evening than you would have had not this “found money episode” occurred. Of course, the opposite can occur. Grandma dies and leaves you $5,000: you may segregate this money and keep it in a low paying bank account as it is “sacred” money.

Pg. 52: If Richard Thaler’s concept of mental accounting is one of two pillars upon which the whole of behavioral economics rests, then prospect theory is the other. Like mental accounting, prospect theory deals with the way we frame decisions, the different ways we label—o code—outcomes, and how they affect our attitude toward risk.

Loss aversion: it takes a $200 gain to offset the psychological impact of a $100 loss. We dread losses twice as much as we appreciate gains.

Sunk cost fallacy: our inability to forget money that’s already been spent (e.g. we paid $70 for a stock and will not sell it until it at least gets back to that price). How about we are given a free ticket to a major event but a terrible snowstorm occurs that night. We probably will wisely not go; but had we bought the ticket, we would of course go. We cannot see this as the same choice.


Status quo bias & the endowment effect: our preference for keeping things the way they are—the status quo bias—combines with a tendency to fall in love with what we own—the endowment effect—to make us resist change.

Confirmation bias: once people develop references—even small ones—they tend to view new information in such a way that it supports those preferences. Or, barring that, they tend to discount any new information that does not fit their preconceived opinions and feelings. This also comes in to play on “first impressions,” they are hard to change. When people want to believe something, they scrutinize relevant information with the following question in mind—“Can I believe this?” This is a rather easy criterion to meet, since even many dubious propositions are supported by at least some evidence. When people do not want to believe something, in contrast, they ask themselves, “Must I believe this?” This is a much higher hurdle to overcome.

Anchoring: is the tendency we all have of latching on to an idea or fact and using it as a reference point for future decisions. For instance, a real estate agent will prefer showing you the more expensive properties first; anything later looks like a good deal.

Pg. 58: When people view a decision as one of preference, they tend to focus on the positive qualities of the options they are considering and ignore the negatives.

Pg. 83: The more choices people face in life, the more likely they are to simply do nothing. This is mostly true when all the choices appear attractive.

Pg. 110: Remember that this was written in 1999: The bedrock belief that home values always appreciate—and that residential real estate is perhaps the best investment an individual can make—was crystallized during a relatively short but dramatic period in the late 1970s, when home prices skyrocketed. What most people forget or ignore, however, is that inflation during that period was soaring as well. Of course home prices were rising; the price of everything was going through the roof. Once inflation was tamed, home prices have performed much as they always have: since 1980, for example, the median price for a U.S. home has risen 1.1 percent annually, after adjusting for inflation—vs. about 6 percent in inflation adjusted terms for the U.S. stock market. (Note: the authors see a housing problem for investors but do not see the then bubble in tech stocks which would implode in another year).