Hidden Mistake #1: Inappropriate Mental Accounting
Definition: Tendency for families to divide money into separate accounts based on subjective criteria.
Typical Example: Treating $100 you received as a gift from Grandma, differently than a $100 bill earned.
Typical Example #2: Having money languishing in a savings account earning 0.25%, while carrying high-interest debt to pay off at 12%.
Cure: Funnel income, no matter the source, into one savings account.
Any â€œfound moneyâ€, such as a tax refund or gift from Grandma, quickly decide where that money is best utilized. As for expenses, occasionally change how you pay. If you always pay with a credit card, try cash. This will get you remembering that all of it, for the purposes of your mental â€œbooksâ€, should be lumped into one, monthly bucket.
Hidden Mistake #2: Manipulative Price Anchoring
Definition: Our tendency to relate the value of a purchase to a price point which, rationally, should have no bearing on the amount spent.
Typical Example: The â€œrule of thumbâ€ to spend two monthsâ€™ salary on an engagement ring.
Typical Example #2: A realtor will tell you that â€œin 2007 this house was going for $500,000 and is now listed at only $350,000!â€ â€¦ causing you to think this house is undervalued.
Cure: For big ticket purchases like a house, car, or engagement ring, ask a friend whose financial values you respect for their input.
For everyday purchases, avoid looking at the MSRP or sticker price. Ask yourself:
Can I afford this today?
What do I really want to spend?
What is this really worth to me?
Marketers are experts at this sort of price-anchoring, and we really should know better â€¦ but yet we still fall prey to it. Try not to let outside sources set up the comparison by which you should be considering such large purchases.
Hidden Mistake #3: Loss Aversion Costing You
Definition: Our consistent tendency to avoid loss, rather than acquiring gain.
Typical Example: An investor is more likely to sell a stock which has increased in value, rather than selling stock that decreased. Over time, her investment portfolio is made up of investments that have decreased.
Cure: Donâ€™t think of selling a stock for less than you paid for it as being a loss. It can actually work as a gain for two reasons:
* Tax deduction (which can really help!)
* The other side of opportunity cost: opportunity GAINED (i.e. you can better utilize that money elsewhere)
So, donâ€™t check your portfolio so often. If you donâ€™t know youâ€™ve lost money, you donâ€™t experience the pain. (And riding the roller-coaster of your portfolioâ€™s value is a waste of emotional space.) Since stock prices go up in the long-run, the longer you go without looking at your portfolio, the greater chance of seeing a gain. Sometimes taking that loss really is the best thing you can do.
Hidden Mistake #4: Following the Herd
Definition: The tendency for us to want to do the same thing as a large group of others, with no thought to whether that action is rational or irrational.
Typical Example #1: Buying when prices are high because everyone else is.
Typical Example #2: Selling when prices are low because everyone else is.
Cure: Warren Buffett said, â€œBe fearful when others are greedy and greedy when others are fearful.â€
Keep this in mind when making your next financial decision. If everyone is telling you to buy this or buy that (i.e. gold, silver, real estate) do the opposite. In the financial investment world, if itâ€™s too good to be true, it usually is. Write up an investment policy statement or contract. Include factors such as:
* Investment objective
* Investment goals
* Desired asset allocation and diversification
* Summary of your risk tolerance
* Rebalancing schedule
Before making any changes, consult with this contract. You can also take advantage of this inherent tendency to do whatâ€™s approved by others to affect positive behavior. For example, letâ€™s say you trying to pay off debt. Tell your 3 closest friends, make an informal contract, sign your name at the bottom, and then email it to them. The pain you would incur from breaking that contract is high relative to the pain of breaking your behavior if you went about it alone.