Handling Finances

Our brains are not well suited to handle finances.  They are great at recognizing patterns (like faces) and interpreting those pattern (recognizing emotions on a wide range of facial features).  In comparison, facial recognition software is extremely difficult to design and even some of the best programs have difficulty with changing light and shadow or different angles.  At the same time, our brains are so good at recognizing patterns, they see them where they are not significant like in clouds, tea leaves, or grilled cheese sandwiches.

We’re particularly poor at evaluating probabilities and risk.  We tend to focus on the possible outcomes while ignoring both the probabilities and magnitudes of the possible outcomes.  For example, when people invested their retirement savings in Enron, they were probably right that the chances of Enron disappearing were very low, but the magnitude of that possibility’s effect on their savings is huge.  If I have a 99% chance of gaining $100 on a $10,000 investment, and a 1% chance of losing $10,000, the value of the investment is about $9,900.  Similarly, some of the best paying state lotteries pay around $0.70 for every dollar collected.  People are happy to purchase a $0.70 piece of paper for $1.00 because of the same mental error – we focus on possible outcomes rather than the statistical value of an investment.

Another huge problem is in our propensity to ignore overall performance and instead continually reset to a new reference point.  Many people have gotten deeply into debt as they borrow money, and then become accustomed to their current level of debt and lose any aversion to further debt.  Similarly, in a market boom, if somebody’s net worth jumps from $500,000 to well over a million, and then drops back to $800.000 in the following slump, they’ll often feel like the market has performed very poorly.  It’s important to recognize and resist this error to stay focused on the overall performance rather than falling into the trap of focusing on recent performance without considering long-term performance.

We also tend to jump to conclusions based on too-little information.  I’ve often seen market analysts judged based on the success or failure of a single stock pick.  An internet-based article that mentions specific stocks is virtually guaranteed to get at least one comment pointing out how a stock mentioned last week/month performed poorly.  Similarly, a money manager who sold just before the bubble burst in 2000 might be featured as an economic genius.  Without much more information, there’s no way to separate skill from luck in these cases.  Given the number of money managers moving money around at any point, the probability that somebody will succeed in any particular set of market conditions is extremely high.  We always hear about those who recently succeeded as if they’re incredibly good at what they do, but since future market conditions are unpredictable, a really good market analyst or manager will likely underperform in highly volatile and risky markets.  Next time you see a story about the latest hot market guru, take a look at the justification.  If the ‘guru’s’ success is based on a single market call or period, discussion of that person is worthless.

There’s a number of other errors we make simply because our brains aren’t optimized for dealing with finances, numbers or statistics, but in general, it’s just very important to think carefully about numbers and probabilities to make sure that good numbers are running our finances, not just what makes us feel the most comfortable.

This entry was posted on Wednesday, February 13th, 2008 at 10:25 am and is filed under Investing, Saving. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.