Actor Jack Lemmon once found Rita Hayworth working her way through a large pile of letters by tearing them up-unopened!
“Stop!” he cried, mortified. “There may be checks in there.” “Oh there are,” Hayworth nonchalantly replied. “But there are also bills. I find it evens up.”
From what malady did Rita Hayworth suffer? Was it wrath, greed, sloth, pride, lust, envy, or gluttony? Oops, wrong list. According to Gary Belsky, co-author of Why Smart People Make Big Money Mistakes, it was a form of the irrational behavior about money that each of us display at one time or another.
Those of you who attended our Retirement Investing Workshop at The Johns Hopkins University-Applied Physics Lab (APL) were entertained by Belsky’s lecture about the emerging field of behavioral economics. In the last decade or more, behavioral economists have developed fascinating information about the psychological forces—patterns of thinking and decisionmaking—behind seemingly irrational behavior.
Belsky described some of the conditions that afflict many of us as investors:
- We fear change.
- We cannot forget our past investment successes or failures.
- We become rooted (for example, holding onto an inherited stock).
- We are overly sensitive to losses.
- We are regret-averse.
- We know too much.
- We misread the data we are given.
Why do investors sell stocks just before the price skyrockets? And, why do those same investors keep a tight grip on a falling stock? Belsky illustrated this through a simple example with two scenarios:
Scenario 1:
You’ve been given $1,000 and are asked to choose between two options. Which option would you choose?
- OPTION A: You win an additional $500.
- OPTION B: You flip a coin. Heads, you get another $1,000. Tails, you gain nothing.
Scenario 2:
You’ve been given $2,000 and are asked to choose between two options. Which option would you choose?
- OPTION A: You lose $500.
- OPTION B: You flip a coin. Heads, you lose $1,000. Tails, you lose nothing.
In Scenario 1, most people chose Option A: They go for the sure thing and win an additional $500. In Scenario 2, most people chose Option B: They gamble and potentially lose $1,000, in order to keep $2,000. However, if they had chosen Option A in both scenarios, they would have the same $1,500 without any risk.
Because people are overly sensitive to losses, they are willing to gamble in order to keep from losing money (Option B). However, they are less willing to gamble to win additional money (Option A). They are like Rita Hayworth-willing to forego cashing checks in order to avoid writing them.
How did you respond to the two scenarios? If you want to know more about Big Money Mistakes, buy Gary Belsky’s book or visit bwfa.com to watch our video recording of his presentation at APL.