Editor’s note: This article was first published in September 2013, in the aftermath of Spain’s property crash. Bank-owned flats for 40,000 euros, the IBEX 35 near 8,900 points, deposits paying 2.75% and the comments on Quabit, which later merged into Neinor Homes, all reflect that moment.
At some point, all of us have made a bad decision about our money, including people we’d consider very intelligent in their lives and careers. In fact, even expert investors sometimes forget that the mind can play tricks on them.
We all have weaknesses and blind spots. The good news is that once we know what they are, and keep firmly in mind that we can get things wrong even if we consider ourselves intelligent, things can start to improve where money is concerned.
1. Anchoring
We’re anchored to popular beliefs: 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 don’t know what it will be 20 years from now, 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’ve said on other occasions, the last thing a young person of 20 to 25 should do is take out a mortgage, because it cuts off their capacity to save and invest.
The exception: right now, with the terms 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 in a crisis (when they’re cheap), not during a property bubble.
2. Financial myopia
You’re 27 to 30, in good health, with a job that pays well and lots of friends to go out with, plus a girlfriend you like to take out to dinner twice a week in your brand-new car, whose horsepower you love to show off.
In that state of well-being that comes with youthful energy, few people think about saving for the day they lose their job, a crisis hits, their health gets worse or any number of other things happen. Nobody, absolutely nobody, feels the need for a financial plan until financial problems smack them in the face. At that point everyone says the same thing: “If only I’d known, if only I’d done it, if only I’d saved everything I spent on… if only I hadn’t bought X, and so on.” But looking back doesn’t solve anything, so today you can look to the future and guard against that situation in the present. Youth is when you need to save, before you take on responsibilities.
3. The gambler’s fallacy
We use this term in investing. It happens when investors rely on past events to predict the future, and when they do, they’re shooting themselves in the foot. Many people who decide to invest in the stock market without really understanding it sometimes get advice from people who claim to be experts and recommend buying shares that have risen 300% over the past year.
One of the principles of the stock market is that “past performance does not predict future results”, so it’s wise to analyse your investment intelligently before buying a share because of how well it has done, since that could change. The gambler’s fallacy is what led retail investors to buy Telefónica at 21 euros and Acciona at 230 euros.
4. Confirmation bias
Whether for good or bad, we all have our own opinion about where to invest our money, while other people hold the opposite view, and they may be wrong, but they may also be right.
We tend not to be objective once we’ve formed an opinion, and that makes us filter information selectively, keeping only what suits us. An example: right now, when I talk about investing in the property developer Quabit, I’m wary of it because of the high risk, but I listen to other people who tell me I could be wrong and miss out on a great investment. That’s when I start again from scratch with the information and the analysis. In the same way, I’m sure those who say Quabit is a good investment take into account the opinions of the people sounding the alarm.
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’d also fall into selective advice bias.
An example: some people asked me about preference shares (preferentes, a hybrid product Spanish banks sold to retail savers), which their bank had sold them with some very eye-catching terms. They asked for my advice, and I told them in no uncertain terms not to even think about it, because only an idiot would buy preference shares at that time. They went back to their banks and the branch manager convinced them otherwise; some even said to me: “So 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 throughout life, in every area, whether starting our own business or investing. Last summer the Spanish stock market hit superb levels for buying, and I myself didn’t build my long-term portfolio with the IBEX at 6,000. So even though I’m someone who isn’t usually afraid of taking risks, I made this mistake at that moment, because sometimes you have to forget that the market could fall even further, as long as the prices suit you.
At times I wonder whether the same thing is happening to me now, with the IBEX close to 8,900 points.
Risk aversion, however, is a much broader mistake, one that even makes us park our money in 12- or 24-month deposits at 2.75% instead of investing it in equities. “To get higher returns, you have to take on more risk.” That much is clear.
6. Overconfidence in our own abilities
I know few people who consider themselves stupid, although, curiously, when it comes to investing money in equities, plenty of people aren’t ashamed to admit they feel clumsy. Well, ironically, those “clumsy” investors end up getting better returns than investors who think they’re too smart to be beaten. As Charlie Munger (Warren Buffett’s right-hand man) put it, “when dumb money acknowledges its limitations, it ceases to be dumb”.
Other people start businesses they don’t understand, thinking they’ll do better than their well-prepared, professional competitors, and others 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’re saving and/or building an emergency fund. Then you receive 500 or 1,000 euros extra from something unexpected. Instead of putting it all into the emergency fund, you treat yourself to something you don’t need, because you don’t think you’re breaking your financial plan, since you’re going to deposit the same amount into the emergency fund as before. It’s like saying: “I haven’t spent 1,000 euros, because those 1,000 euros were a gift”, when the truth is you have spent 1,000 euros, probably 800 euros more than your financial plan allowed you to spend.
Another example: a few years ago, a friend who runs a bar and restaurant business renovated the downstairs area. I asked him whether he didn’t regret spending 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 replied with all the conviction in the world: “Yes, because the beer company gave me 6,000 euros, and that’s what the renovation cost.” He’s completely convinced the renovation didn’t cost him any money, when in fact he spent 6,000 euros that he could now have put aside for the lean times that will come in September.
And those, 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: Zdenko Zivkovic, CC BY 2.0, via Flickr.
