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Monday, 25 June 2007

Seven Money Mistakes to Avoid

by Nicole Bullock and Janet Paskin

We all make financial mistakes, and they add up.

Consider: From 1986 to 2005, the Standard & Poor's 500 returned 12% annually, but thanks to overzealous trading, the average investor in stock mutual funds made just 4%, according to Dalbar, a Boston-based financial-services research firm. Homeowners pay high insurance premiums to keep deductibles low, but only 7% report claims each year. And 74% of Americans overpaid their taxes in 2005 -- essentially giving the government an interest-free loan.

Why? A developing discipline known as behavioral economics seeks to answer that question, but it boils down to this: Academic research tells us that emotions and experiences can distort our financial decisions. While our mistakes are rarely the result of a single mental error, our feelings can make us fumble. Below, seven big financial mistakes and the psychology behind them.

1. Saving with the right hand and spending with the left
DIAGNOSIS: Mental accounting
SYMPTOMS: Keeping a savings account that pays 5% interest while paying Visa 15%; thinking a tax refund equals mad money; obsessing over the price of a new car, but failing to monitor the weekly grocery bill.

Another way to think of "mental accounting" is separating money into buckets, each with a different purpose. It's not always a mistake -- it is the premise behind budgeting, for example -- but looking at your finances in parts without seeing the whole picture can hide costs and charges you could otherwise avoid. Consider a $5,000 tax refund. Woo-hoo! Right? Wrong. If you put your overpayments in a high-interest savings account throughout the year, you would net about $135 in interest instead of giving an interest-free loan to Uncle Sam.

2. Playing it too safe

DIAGNOSIS: Loss aversion
SYMPTOMS: Quick to sell winning stocks but slow to sell losing ones; putting too much cash in money-market funds and not enough in stocks; reluctance to trade away what you already have, even for something more valuable.

No one likes losing money -- a truism that economists call "loss aversion." Because we can avoid only losses that we recognize, we tend to focus on immediate costs, while ignoring more subtle costs and even savings. For example, we should recognize that getting a $4 discount is worth as much as avoiding a $4 surcharge. But most of us would rather avoid that surcharge. By being "loss averse," investors open the door to a more insidious cost, the toll that inflation will take on their savings.

3. Looking into a cloudy crystal ball

DIAGNOSIS: Misunderstanding risk
SYMPTOMS: Putting too much of your savings in your company's stock; having very low insurance deductibles; thinking small-cap stocks will rise forever.

More than two-thirds of adult Americans have life insurance. The bad news is that many are neglecting a bigger risk. People between 35 and 64 years old are six times more likely to be injured badly enough to miss an extended amount of work than they are to die. So why do fewer than a third of us have disability coverage? That error reflects what economists and psychologists sometimes call "the availability bias," a mental shortcut we use to gauge risk. It all adds up to what University of Chicago researcher Cass Sunstein calls probability neglect. "We tend to ask what's the worst -- or best -- that could happen," he says. "Instead, we should be asking, 'What's likely to happen?'"

4. Living in the moment

DIAGNOSIS: Procrastination
SYMPTOMS: Failing to enroll in a 401(k) plan; not coming up with a monthly budget; waiting until the last minute to make your IRA contribution.

The propensity to procrastinate, behavioral economists say, is one reason nearly half of employees don't participate in their 401(k) plan or contribute enough to get the full company match -- essentially turning down free money. "There is a tendency to value immediate costs and immediate rewards much more than delayed costs and delayed rewards," says David Laibson, an economics professor at Harvard. To be fair, some households can't afford to give up any of the paycheck to savings, even if the company will automatically pony up too. Laibson, however, studied employees who could contribute to 401(k) plans, get the match and still have access to the money in short order. About half still weren't contributing enough to get the full match, and of that half, most weren't enrolled at all.

5. Throwing good money after bad

DIAGNOSIS: Sunk-cost effect
SYMPTOMS: Hanging on to a lagging mutual fund because you paid an upfront sales charge; making repairs that cost more than your car is worth; making decisions about how to spend time or money based on how much time and money you've already spent.

The upfront money we spend to make an investment -- the "sunk cost" -- colors the way we see its prospects for the future. Mutual fund sales charges are sunk costs. Of course, you hope your investment pays off and the fund outperforms. But when it comes to reevaluating -- whether to sell the mutual fund -- a "rational" economic perspective tells us the sunk costs shouldn't matter. They're gone. We'd be better off making the decision by weighing future gains and losses.

6. Letting your ego get in the way

DIAGNOSIS: Overconfidence
SYMPTOMS: Frequent trading; concentrating picks among a handful of "surefire winners"; thinking you're an above-average driver.

Studies show that we often tend to overestimate our abilities. Of course, confidence and optimism aren't necessarily bad. But in the stock market, overconfidence leads people to believe that they can beat the market when, more often than not, they can't. The consequences are high-risk investments, overtrading and under-diversification, all of which chip away at long-term returns. In their study "Trading Is Hazardous to Your Wealth," University of California professors Brad Barber and Terrance Odean found that individual investors who trade actively trailed the overall market by 3.7 percentage points a year. Odean says that while many people believe they can identify winners, they not only miss the mark but also rack up a lot of commissions and other trading costs.

7. Following the crowd

DIAGNOSIS: Herding
SYMPTOMS: Buying ethanol stocks because everyone says they're the next big thing; dumping your stock fund after a steep market decline; taking stock tips from family and friends.

Nearly two decades after the stock market crash of 1987, the debate continues about what really caused a 23% plunge in the Dow Jones Industrial Average and massive drops in stock markets around the world. Theories range from cascading electronic trades to a windstorm in London. Behavioral economists, however, see investors acting like lemmings. The sellers couldn't resist the pull of the crowd even though it was pushing them in precisely the wrong direction.

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