Are we really as rational as we think we are?

Lately I’ve been taking an interest in behavioral economics, also known as behavioral finance. This is the idea that our biases influence us to make decisions that would not otherwise be considered rational or logical.

Traditional economics assumes that we as consumers are completely rational and will make decisions based on utility versus cost. But is this really the case? For example, consider the decision to have children.

Now the first objection I can imagine someone having (because I have it myself) is that having children is not a financial decision. But children are a huge financial burden which is exactly the point here. We have a bias against looking at the decision to have children as a financial decision.

Personally, emotionally, I want to have kids. But if I think about it logically, I can’t really come up with a good reason why I should. They cost a lot in food, clothing, education, and housing expenses. They require a lot of your daily energy, so you are tired often. They are a huge time commitment that may take away from time in your career or your hobbies. They lock you into a particular schedule and way of life that can restrict the options you have. And when it’s all said and done, there’s no guarantee that you will get anything back.

But even knowing and realizing all of that, I still want to have them. So based on this one example alone it’s pretty clear to me that the assumption of a rational and logical consumer is a flawed assumption. Enter behavioral economics.

Stumbling on Happiness

I recently read two books that are based on this subject. The first was called “Stumbling on Happiness”, by Daniel Gilbert. The subject matter of the book was very interesting. He spent most of the book pounding the point that the brain plays tricks on us in order to be more efficient, and that we don’t even realize it because it happens so often.

He points out that our brains only store a few important details about an event, and then recreate the non-stored details when we remember that event. Our brains also alter our memories to better fit our current beliefs. For example, we often don’t remember how much we disliked something at the time we were going through it. And further we have a hard time predicting how happy or sad we will be in the future given a certain event. Think about the last time that you just had to get some thing, but once you had it, it sat in the corner, or you only wore it once.

In fact, I’m having this problem right now. As I’m looking back over my notes about the book, I see that I disliked the writing style while I was reading it. I noted that I thought he rambled on and danced around the point rather than just stating the point. But at this moment I don’t feel that way. I only remember that I thought the book was interesting.

He spends almost 238 pages trying to prove to us that our brains trick us on a regular basis. Then the culmination of the book is wrapped up in a few pages. The basic gist is that if you want to know if you’ll be happy doing something, then ask someone who is already doing it how they feel. Note that it has to be someone currently doing the thing, not someone who did it before because that person’s brain will already have altered their memory and they will unintentionally be misrepresenting the thing to you. And also note that you are supposed to be asking the person how they feel, not about the specific details of the thing.

In fact, the details will be distracting to you and could give you a false impression of the thing. But then he notes that the caveat to all this is that you have a bias that says you are unique and that you are the best judge of what will make you happy. And even if you are told that studies and experiments show that your best chance of estimating your happiness is to listen to how someone who is currently doing the thing feels, you’ll still ask to see the details.

Why Smart People Make Big Money Mistakes

The second book that I read recently on the topic of behavioral economics was “Why Smart People Make Big Money Mistakes And How To Correct Them: Lessons From The New Science Of Behavioral Economics”, by Gary Belsky and Thomas Gilovich. Despite the length of the title, the book wasn’t too long, but it listed a number of interesting biases that we suffer from as financial animals.

Mental Accounting: The tendency to treat some money as different from other money. For example, gift money, tax return money, or found money is generally treated differently from earned paycheck money. Personally, I use this bias in my favor. My retirement accounts and savings are completely off limits. Money in there doesn’t even exist any more for normal consumption. But then I also have a “blow” account that I can spend on anything I want each month, so I don’t feel cheated or restricted.

Loss Aversion and Sunk Cost Fallacy: The tendency to throw good money after bad. This goes back to the idea that we would rather forgo a gain than suffer a loss and that we feel the loss more keenly than we feel a gain. (I talked about this briefly in the last post.)

Status Quo and Endowment Effect: This is the idea that I like something simply because it is mine, or that I will value it higher when selling it than if I was buying it. Meaning I would ask for a higher price than I would be willing to pay for a thing if I was looking to buy the same thing. This is also the idea that we are reluctant to sell a stock that we own because it is ours already, when we wouldn’t buy it if we didn’t already own it.

Money Illusion, Bigness Bias, and Math and Probability Ignorance: This goes back to the human mind’s ability to trick us. We have heuristics, or rules of thumb, we use to help us quickly make decisions. Examples would be ignoring small expenses like trading costs, or inflation, or ignoring the benefits of small savings over a long period. This hits us hardest when we assume that waiting to start investing and saving is no big deal. Almost every basic investing book starts out with a description of the two brothers that start investing at different times, and then the one who started earliest and then stopped is the richer one in the end.

Anchoring and Confirmation Bias: These are the most interesting to me. The anchoring bias says that you will take whatever first number you come up with and compare everything else to it. So even if it has no relevance what so ever (like you made it up yourself), it will still affect the outcome of your guess or decision. Like the estimate of a house’s value. Whatever the sales price says, unless you had a previous number shown to you (like a tax value, or a comparables value), you’ll view all subsequent numbers in comparison to that. The confirmation bias says that after you have an initial leaning (such as this initial number) you will start to actively seek information that confirms your believe, and actively avoid information that might disprove it. Think about how often you read commentary on a subject that is opposite to how you already feel on that subject. This would be especially true for emotionally charged issues, like religion, or politics. Now the real kicker here is that as soon as you have a belief, you should start looking for information that will disprove this belief because more positive information is just ego stroking (“I was right all along”), but one disproving fact could change your perspective and show you the truth of the matter. I think I’ve read before that Charlie Munger says you shouldn’t be allowed to express an opinion until you can argue against it better than its opponents can. It seems like this would follow along the same lines.

Overconfidence: The idea that the average person thinks they are smarter, cleverer, luckier, or know more than the average person. A theme of the book is to invest all your money in index funds and not try to beat the market and this along with small fees are parts of their arguments for this type of investing.

Information Cascades and Relying on the Financial Moves of Others: This is the basic premise of how manias and panics work. People see other people making money and they jump into the market creating a mania pushing the prices way up. No one is left to buy, so then people start to sell. People see other people selling and so they sell, pushing the price down further causing more people to sell in a panic. This is a pretty good argument for why you should avoid the news entirely and probably ignore the value of your portfolio for long stretches as well. Although I will say I would make certain to have the down side limited and the upside as open as possible like by owning put options on your long positions or placing stop loss orders.

At the end of the book they give some “steps to take” which are okay, but some of which I disagree with.

The ones I agreed with were:
– Raise your insurance deductibles and save the difference in premiums to pay the deductible if you ever have to.
– Self insure against small losses with an emergency fund instead of insurance.
– Max out on retirement plans (especially in the current tax environment).
– Setup payroll deductions to help you save (out of sight out of mind mental accounting)
– Keep track of expenses each month. I do this, but I don’t expect that everyone can. The authors suggest trying it for just one month to get an idea of where you really spend your money.

The ones I disagreed with were:
– “Pay off credit cards or high interest debt with emergency funds.” This seems foolish to me. It’s treating the symptom, but ignoring the disease. The times that I have seen people do this, they are back in debt within a year and then don’t have an emergency fund to fall back on if they need it. Keep the emergency fund, figure out why you’re overspending, and then pay it down from your normal income. Yes, it will take longer and yes it will be more expensive, but this person has already shown that they won’t be doing anything productive with the money that they would be saving in interest charges.
– “Switch to index funds for all stock investing.” Maybe. I understand the argument that most mutual fund managers don’t beat the index funds, and that most mutual fund investors do even worse that the mutual fund managers because the investors try to time the market. And I might be suffering from the overconfidence bias here, but I think it’s possible to pick good companies to hold for the long term that will do better than index funds. And these companies aren’t going to charge me a management fee to hold their stock.
– “Diversify your investments.” Again, maybe. The investor that does this probably has an easier time riding out down turns because when one asset type declines in price, another type will probably appreciate and so the two will cancel each other out on an overall basis. And again, I’m probably suffering from overconfidence, but by diversifying your investments, you’re also diluting your gains. I’d prefer to concentrate my investments, but make sure that my downside is limited, like with purchasing stocks protected by stop losses or puts, or by purchasing calls.
– “Review your assets.” I agree with the principle, but not with the frequency. They suggest a 3 month period between checkups. That seems a bit often given our tendency to try to adjust and overtrade. I’d probably try to take an overview on an annual basis instead. But again, you should know your maximum downside first before leaving your portfolio unwatched.

So as a conclusion to this particularly long winded review, I would say this book was pretty good. I think it’s pretty useful to know what biases you might be fighting and how you might be sabotaging yourself in your attempts at investing profitably.

Experiments in News Deprivation

After reading the “Fooled by Randomness” book from last month’s post, noting some of the dangers news presents, and given the biases I was reading about in behavioral finance, I decided to try out the idea of ignoring the news.

I cancelled all of my daily financial emails, even the ones I received as part of my paid subscriptions. Then I put stop loss orders in or purchased puts on the positions in my portfolio that were not already limited on the downside. Then I went dark. I haven’t read any news stories, watched the evening news, checked the value of my portfolio, or even the value of the general indexes. So I really have no idea what the market is doing right now or even what it has done in the last month.

So far this is a very freeing state to be in. My emotions are not being jerked around by the jagged lines of the stock charts, the inciting commentary of the financial journalists, or even the jawboning of the politicians. And as a bonus I have more time to do what I want like read the books above, write this post, or watch movies. And so far I don’t feel like I’m missing anything other than that nagging worried feeling I used to have that said I should be “doing something”.

There is the occasional pang of desire to check the stock charts. But that feels more like withdrawal from the “gambling excitement” or maybe the pull of habit than anything else. And I expect as time passes those pangs will become less and less frequent until they die off completely.

If my portfolio is doing poorly, I’m blissfully unaware. I know what the maximum damage is, so I don’t have any worry because I’m already prepared for that to be the number that I will see at the end of my experiment. And most likely I’ll be pleasantly surprised by a number that is either slightly or significantly higher than that worst case scenario because time should allow the long term advantage of my investing strategies to shine through.

Walter Capital Funding

For the last six months and counting, I have been investing some money with a hard money lender called Walter Capital Funding. Hard money lenders are real estate lenders who base the amount of money they will lend on the value of the property rather than the credit worthiness of the borrower. The interest rates they charge are fairly high, but they can do a loan much more quickly than a conventional bank can. So real estate investors will sometimes use these lenders as bridge loans while they fix up a house in order to get traditional financing, or in order to get the house ready for sale. So by investing with a hard money lender, you in effect become a bank and get paid interest payments by the borrower.

Walter Capital Funding is based in Austin, TX. (Before I went dark, the media was reporting that real estate was going down in the rest of the country, but Austin is not having this problem.) They pay 10% on investments of $25k-$50k, and 12% on investments of $50k and up. The investments are typically 12 months or less and are interest only loans, so each month you get paid 1% of your total investment (assuming a 12% interest rate), and the lump sum back when the loan ends. There are no fees paid by the investor. And you get to pick and choose which investments you want to fund.

Their website is http://www.securedinvestments.net/. If you decide you want to try them out be sure to tell them that you were referred by Dividendium. They will then pay a referral fee to Dividendium of 1% of your initial investment, which Dividendium will then pay half of to you. So in effect you’ll be making at least 12.5% on that first loan.

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