There's a certain sort of business book whose title seems to be created by randomly generating a combination of the following words: "smart," "big," "secrets," "money," "rich," "quick," "mistakes," "negotiate," and "rules." Put a few of those words together in a combination that hints at the "secrets" of getting "rich" "quick" using a few easy "rules," and the odds of a bestseller increase exponentially.
Despite its banal title, Why Smart People Make Big Money Mistakes is not one of those books. Personal finance and sports journalist Gary Belsky and Cornell University psychology professor Thomas Gilovich instead give a fascinating overview of behavioral economics, which uses the principles of psychology and economics to explain why we make irrational or illogical financial decisions.
Economics assumes that humans are rational and efficient in dealing with money. That is, "we know what we want, what we want is for our own good, and we know (or will eventually figure out) the best way to get it." But that's the rosy view, as Belsky and Gilovich say. In fact, we rely on a lot of mental shortcuts when we make economic decisions -- things like assuming that a long line at a restaurant means good food instead of poky service -- and not all of them are grounded in reality.One giant mistake is the tendency to value some dollars less than others, and thus to waste them -- a concept called mental accounting. Are you more likely to splurge on something with your $300 tax refund or $300 from your savings? If you said the former, you're a victim of mental accounting: the $300 is the same, no matter where it comes from. If you saw a lamp for $100 at one store and knew it sold for $75 at another store five blocks away, would you walk to save the money? What about if it was a dining room set on sale for $1,775, and you could get it for $1,750 five blocks away? If you'd walk for the first, but not the second, again, blame mental accounting -- it's $25 saved or spent, either way. Another common example of economic irrationality is the sunk cost fallacy, or what your grandmother might call "throwing good money after bad." It's the tendency to make financial decisions based on previous investments. Would you be more likely to ski in a blinding snowstorm if you'd paid $50 for your lift ticket than if you got it free? The money shouldn't be a factor in your decision, since it's already spent (or sunk), write Belsky and Gilovich. And you may incur more losses by skiing and risking injury. The authors also use examples from the real-life world of personal finance. One chapter is devoted to the (rather depressing) idea that "you're probably not as smart as you think you are." Put more delicately, investors tend to be overconfident: They make big spending decisions based on incomplete research, credit their own skills with stock picks that go right but forget those that don't perform, and trade frequently to try to beat the market. Belsky and Gilovich conclude with a list of practicable suggestions -- including raising your insurance deductible, switching to index funds from so-called "hot" investments, and paying off credit card debt with your emergency funds. One quibble: They don't offer many suggestions for how to change the bad habits that caused the mistakes in the first place, saying that you'll be "fighting habits that are often rewarded in other ways and are thus held dear." Still, whether you prefer the term behavioral economics or "big" "money" "mistakes," the insight Belsky and Gilovich provide makes their personal finance book one that actually deserves to hit the bestseller list.