Editor’s note: This article was first published in June 2018. Its market references appear to date from around 2013, so the article may be an older post republished. They include the IBEX close to 8,900 points, deposits paying 2.75%, bank-owned flats for 40,000 euros and Telefónica at €21, and they should be read as figures from that earlier period.
There are certain psychological reasons why smart people can end up making bad decisions about money.
At some point, all of us have made a bad decision about our money, even people we would consider very intelligent in their lives and careers. In fact, even expert investors sometimes forget that the mind plays tricks on us.
We all have weaknesses and shortcomings, but the good news is that once we know those weaknesses, and keep firmly in mind that we can get things wrong even though we consider ourselves intelligent, everything to do with money can start to improve.
1. Anchoring
We are anchored in popular beliefs, such as the idea that you should buy a new car on instalments and get into a home of your own as soon as possible, because paying rent is throwing money away. This crisis has already taught us that buying our own home with a mortgage is one of the riskiest investments there is: we know our financial situation today, but we do not know what it will be in 20 years’ time. So if we pay for a home for 15 years and end up losing it, that really is throwing money away.
From a financial point of view, though, that would be the least of it. As we have said on other occasions, the last thing a young person aged 20 to 25 should do is take on a mortgage, because it cuts off their ability to save and invest.
Exception: right now, with the terms the banks are offering (on flats the banks themselves own) and with flats going for as little as 40,000 euros, owning your home might be a good idea. As with shares, houses should be bought during a crisis (when they are cheap), not during a housing bubble.
See also: Why your luxury car doesn’t impress smart people
2. Financial short-sightedness
You are 27 to 30 years old, in good health, with a job that pays you well, lots of friends to go out with, and a girlfriend you like to take out to dinner twice a week in your newly bought car, whose horsepower you love to show off.
In that sense of well-being that the vitality of youth brings, few people think about saving for when they lose their job, a crisis hits, their health gets worse, or any number of other things. Nobody, absolutely nobody, feels the need for a financial plan until financial problems hit them right in the face. At that point everyone says the same thing: “If I had known, if I had done it, if I had saved everything I spent on… if I hadn’t bought X, etc.” But looking back solves nothing, so today you can look ahead and prevent that situation in the present. Youth is when you need to save, before you take on a load of responsibilities.
See also: Why you don’t have money and success, according to Jordan Belfort
3. The gambler’s fallacy
We use this term in investing, and it happens when investors rely on past events to predict the future. When that happens, the investor is shooting himself in the foot. Many people who decide to invest in the stock market without really understanding it sometimes take advice from people who claim to be experts and who recommend buying shares that have risen 300% in the past year.
One of the principles of the stock market is that “past performance does not predict future results”, so it is wise to analyse your investment intelligently before buying a stock just because it has done so well, since that situation could change. The gambler’s fallacy is what led retail investors to buy Telefónica at €21 and Acciona at €230.
4. Confirmation bias
For better or for worse, we all have our own opinion about where to invest our money, while some people hold the opposite view, and they may be wrong, but they may also be right.
We are not usually objective once we have an opinion of our own, and that makes us filter information selectively, keeping only what suits us. Example: at the moment, when I talk about investing in the property company Quabit, I am wary of that investment because of its high risk, but I listen to other people who tell me I could be wrong and miss out on a great investment. That is when I go back to square one with the information and the analysis. In the same way, I am sure that those who say Quabit is a good investment take into account the opinions of the people who are raising the alarm.
See also: 5 questions about your money you should be able to answer
In other words, we should have our own opinion and even let our intuition guide us, but always after analysing all the information (positive and negative), because otherwise we would also fall into selective advice bias.
Example: some people asked me about preferentes (preference shares that Spanish banks sold to their retail customers), for which their bank had promised them some very eye-catching terms. They asked for my advice and I urged them not even to think about it, since only an idiot would buy preferentes at that time. They went back to their banks and the branch manager convinced them otherwise; some of them even said to me: “Do you think you know more than a bank manager?” That would be selective advice bias within confirmation bias, traditionally known as an incredible, monstrous blunder.
5. Risk aversion
This may be one of the mistakes we make most often throughout our lives, in every area, whether starting a business of our own or investing. Last summer the Spanish stock market hit superb levels for buying, and I myself did not build my long-term portfolio with the IBEX at 6,000. In other words, even though risk-taking does not usually scare me, at that moment I made this mistake, because sometimes you have to forget that the market could fall even further, as long as the prices are attractive.
At times I wonder whether the same thing might be happening to me now, with the IBEX close to 8,900 points.
Risk aversion, however, is a much broader mistake, one that even leads us to park our money in 12- or 24-month deposits paying 2.75% instead of investing it in equities. “To get higher returns, you have to take on more risk.” That much is clear.
See also: 10 money tips from the most successful people
6. Overconfidence in our own abilities
I know few people who consider themselves stupid, although, curiously, when it comes to investing money in equities, many people are not ashamed to admit they feel clumsy. Well, ironically, those clumsy people end up getting better returns than investors who think they are too smart to be beaten. As Charlie Munger (Warren Buffett’s right-hand man) said, “when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”
See also: 11 things you pay more for than you should, and how to save on them
Other people start businesses they don’t understand, thinking they will do better than their well-trained, professional competitors, and some even go from labourers to big builders, or even to real estate investors, without having read a single finance book.
7. Misunderstanding money in general
Suppose you are saving and/or building an emergency fund. Then you receive an extra 500 or 1,000 euros from something unexpected. Instead of putting all of it into the emergency fund, you treat yourself to something you don’t need, because you don’t think you are breaking your financial plan, since you are still going to put the same amount into the emergency fund. It is like saying: “I haven’t spent €1,000, because that €1,000 was a gift,” when the truth is that you have spent €1,000, which is probably €800 more than your financial plan allowed you to spend.
Another example: a few years ago, a friend who runs a bar and restaurant renovated the downstairs area. I asked him whether it didn’t bother him to spend money on something that could have waited. He told me the renovation had cost him nothing. So I asked him: “What do you mean it cost you nothing?”
He told me with all the conviction in the world: “It’s true, because the beer company gave me €6,000 and that’s what the renovation cost.” He is completely convinced that the renovation didn’t cost him any money, when the truth is that he has spent €6,000 that he could now have saved for the lean times that will come in September.
And these, basically, are the psychological reasons why we tend to act foolishly with money, regardless of how intelligent we are. Any of us could fall into one of these mistakes.
Featured image: conorwithonen, CC BY 2.0, via Flickr.
