Problem 3: Not Looking at All Sides of a Problem

This problem is usually having a point of view on an investment situation where you may have taken someone else’s word on it or never really given the question serious thought. One common financial example of this the use of a financial advisor to assist you in buying and selling stocks, mutual funds, or other investments. Whenever I consider that advice from this kind of source, I ask several questions about the source of the advice. Some basic ones may include the following:

- Does this advisor have anything to gain or lose by my decision?

- Is this advice based on the advisors own expertise or on someone else’s?

- Is this person following their on advice on that issue?

- Is the advice based on a fair analysis or a biased analysis?

- Is it to my advantage to even consider taking this advice?

- If the advisor makes any performance claim, can the claim be backed up?

- Does the advice make sense?

- After further investigation and research on my part, does the advice still make sense?

- Does not following the advice make better sense?

The current rash of mortgage problems in the US, issues like short sales because of underwater mortgages and foreclosures, is one example of this kind of decision problem in action. Many people got into this situation because they didn’t think about the consequences of taking out a home equity loan to buy expensive toys, or the possible negative consequences of an adjustable rate loan.

There are many more questions that one can ask, but the basic point is that every decision can be looked at in more than one way. It is to your advantage to ask a few questions and do at least a little work to understand what may be behind a piece of advice.

Next Lesson: Being Overconfident In Your Predictions

Money Decision Problem 2: Solving the Wrong Problem

You can have the greatest system in the world for analyzing and solving your personal or business money problems, but you would be wasting your time if you were solving the wrong problem. This usually happens if you do not think through a problem before you start to solve it. To understand how to approach a particular problem you should understand at least these things about the problem:

1. What are the limits to problem at hand?
2. How do you define a good or a bad outcome to the decision?
3. How should you measure the outcomes?
4. What do you bring mentally and psychologically to the decision table?
5. What are other ways to look at the problem?

A Mutual Fund Example
One example of solving the wrong problem is to pursue a high rate of return from a mutual fund investments without first deciding what kind of comparison or benchmark you should use to determine if the return is high enough. For example, index mutual funds that are designed to mirror the results of the Standard and Poor’s 500 index consistently outperform rough 80% of all mutual funds. The original problem may have been how to choose mutual funds with high returns. A better problem to solve would be how choose mutual funds which consistently perform better than the S&P 500.

Final Thoughts
Remember that most problems involving money usually involve something else besides money or mathematics. If you focus on the parts of the problem that are objective and that can be measured or solved with common with equations and spreadsheets, you may miss the most important part of the problem.

Next Lesson: Not Looking at All Sides of a Problem

Money Decision Problem 1: Not Taking the Time to Think About the Problem

Money Decision Problem 1: Not Taking the Time to Think About the Problem and the Decisions that Must Be Made

Before you make a financial decision, you have to know something about your needs, the effect your decision may have, and how you go about making a decision. Some common money decisions that often happens too quickly is what credit card you should have, whether to buy or sell a stock, or whether to go into debt to replace your boring old (and paid off) car for a shiny new one. Taking the time to make a proper decision can save you a lot of frustration and regret, especially if you do it consistently.

A Credit Card Example
Let’s look at the credit card situation more closely. There could be dozens of reasons why you suddenly decide that you need a new credit card. You might not have one at all, but one day you decide to rent a car and find out that you need a credit card. You might have a card already, but you find a way to transfer balances and reduce your interest rate for the first six months. Even if you think you need to take action right now, it always makes sense to think it through to see if it is the right decision for you. The following are just some of the questions you should ask yourself before you sign on the dotted line:

1. What do you want to accomplish when making the decision? - At the very least, figure out if it is a short term or long term goal.
2. Who will be making the decision? - Typically anyone who will be responsible for paying the bill and whoever will be allowed to make charges on the card.
3. How should the decision be made? - Figure out things like whether you need to decide after comparing other options, or if any one person will have veto power.
4. Does the decision significantly affect other decisions?
5. Does the decision have to be made at all? - Think about what would happen if you took no action.
6. Does the decision have to be made by some kind of deadline?
7. What’s the worst that will happen if you don’t make a decision?
8. How much time do you need to make a decision?
9. What kind of options do you have?
10. Do you have any experience making this kind of decision, and if so what did you learn?

Once the background questions are settled and you have a good understanding of your overall situation, you have to start dealing with the decision making process. You should finish gathering any information that you need to make a decision. For credit cards, this would be things like late fees or other penalties, how much interest you will be charged, and what kind of no-interest grace period you have. These kinds of details should be spelled out in the agreement. If you don’t understand it, don’t sign it. If you don’t see it in the agreement, then it’s not part of the deal.

The next big steps are making the decision and carrying it out. If you decide to do something, then follow through. If you decide to do nothing, then take no action, no matter how tempting it may be. If you decide to change your mind, go through the same decision process. Don’t make the mistake of being logical and systematic the first time through and then being very informal the second time you wrestle with the same decision. Every decision is a combination of your analysis and your judgment. If you have a consistent process, you’ll likely improve the quality of both your analysis and your judgment.

Final Thoughts
Keep in mind that a credit card can turn out to be a long-term relationship. If you pay your bills in full every month, it can be a very happy and harmonious relationship. If you fall behind, it can turn real ugly real quick.

Next Lesson: Solving the Wrong Problem

Making Money Decisions

Do you every wonder about your ability to make good decisions about money? Do you think you need to know something special to be better than average? Before you got that seminar, buy that book, or sign up for that MBA program, you should take some time to look at how you make money decisions. Success in investing, or choosing the best mortgage, or picking a sensible credit card all starts with using your mind to figure out your options and to make decisions.

The Making Money Decisions posts will take you through a few basics of decision making and take some of the stress out of making decisions about your money.

The ability to make good decisions is as skill that can be improved through practice and the use of the proper techniques. None of these techniques are based on any sophisticated mathematical or psychological concepts. If anything, the basic techniques of decision making are about figuring out what information you need for a decision, making a clear decision, and checking up on the results afterward. It is about finding the proper balance between intuition and analysis and recognizing that you can develop all the decision making skills that you need to become a better investor.

Next Lesson: Taking the time to think about your money problem

What is Threshold of Perception for Money?

Locus Pocus

If you have something happen to you, do you blame it on yourself, or blame it on external causes?

It’s an odd question, but an interesting one as it deals with your personal locus of control. But, that’s jumping ahead. Let’s start with defining a locus of control.

In psychology, the locus of control is a scale that defines a person’s beliefs about what causes good or bad results in their life. For example, you might know someone who always blames themselves when things go wrong, or someone who credits only good or bad luck for what happens to them. People like these define either end of the spectrum on the locus of control. People who blame themselves for everything in their lives have an internal locus. People who blame higher powers, luck, or the environment for occurrences have an external locus of control.

Now, it’s worthwhile repeating that this is a scale, not an either-or proposition. People can display different characteristics of either locus for different issues. The big question we’ll ask here though is: What is your locus of control with money?

When you can’t run out of cash, is it because you had bad luck and needed to spend more than you had thought? Or is it because you forgot to plan ahead and have an emergency fund? Knowing your locus of control with regard to money can help you to plan in ways that work with your financial psychology as opposed to against it. And a plan that you can work with is a plan you’re more likely to follow.

Don’t let your psychological beliefs get in the way of you being financially successful. A good financial plan can help to protect you against both internally and externally caused problems.

Bargains and behavior

A recent post on Get Rich Slowly is ostensibly about how J.D. and his wife cleaned up his mom’s house and found that she was a packrat; but it’s really about how buying and hoarding “bargains” can be a trap. The house contained many unopened bulk packages of food that were long past their best-by date, newspapers from ten years ago, presents bought for five-year-old grandchildren who are now nine. As J.D. pointed out, a bargain isn’t a bargain if what you buy is wasted.

This post strikes home with me because my husband and I are working on the same issue. “My favorite chips are on sale!” I’ll say. “Let’s buy four!” We do, and instead of stockpiling them as I meant to, they’re gone within three weeks because I like those chips so much. “The bigger bag of ham is cheaper per ounce, let’s get that,” my husband says, but then half the bag goes bad before he eats it. We’re dealing with slightly different aspects of the same problem: we’re buying more than we normally would in the expectation that our future behavior will justify the purchase, but we don’t adjust our behavior accordingly. If there’s a tasty snack around, I’m inclined to eat it, not save it, even when I know I’ve had some recently. If my husband isn’t reminded that there’s food in the fridge, he tends to forget about it and eats other things that are more visible.

The key here is that it’s not our purchasing behavior that’s bad; it’s our behavior after the purchase that’s the problem. There are two solutions here: don’t buy the “bargains” when we know they won’t, in the end, be true bargains; or adjust our behavior to take full advantage of our purchases. I could put extra snacks in the rear of the pantry that’s harder to get to, to remind me that they’re meant to be rationed. My husband could freeze half his bags of lunchmeat, or I could remind him that he still has ham left. Behavior can be hard to change; whether or not a bargain at the store is worth it depends entirely on the person faced with the purchase. Is it worth it for you?

Money in marriage

This is a post that discusses this post about a man who finds out that his wife has been hiding credit cards from him while he’s been working to pay off their debt. It’s an interesting story, but what really got my attention was the comments.

The post describes a husband dealing with his wife’s duplicity in finance. Many of the commenters were also men who wrote about their wives who hid their spending, were heedless overspenders, or were generally deceitful. There were also several women saying “It’s not just women who are bad at money, my husband’s the spender and I’m the saver…” and many comments to the tune of “Of course this happened, women are all bad with money and love to overspend, don’t marry them or you’ll be wasting your time and hard-earned cash.”

Being a female saver, I don’t like the tone that these men took. I wouldn’t like it even if I were a spendthrift, because they were stereotyping women, using their own experiences and the “stereotypes become stereotypes because they’re generally true” excuse for calling all women bad at finances.

This is, flatly, not true. Yes, there are certainly women who are terrible spendthrifts, either intentionally or accidentally, because they love it or to make up for some other psychological lack. There are men who are the same way. There are women and men who are masterful with their finances. A handful of people’s experiences doesn’t prove anything. The plural of anecdote is not data.

There’s truth in the idea that women are less knowledgeable about and less responsible for their money on average, absolutely. This is because our society is still growing out of the societal norm wherein men earned money and were expected to handle it, while women got allowances and weren’t expected to know anything about finance. That’s changed, fairly recently and perhaps too suddenly for some; there are women out there who know nothing about money because they haven’t been taught and haven’t been expected to learn, but suddenly they have access to $20,000 in credit and no real idea of what that means.

But you can always find an example of whatever stereotype you prefer to hold. The bigger truth is that it’s not women who are bad at money or men who are bad at money; some people are bad at money. And if you’re married to one of those, it’s important to understand that and be able to work with him or her to figure out your finances together. And it’s vital not to assume that your wife is a compulsive spender because she’s female, just as it’s important not to assume your husband can fix your car because he’s male.

There’s some interesting information here on how marriage and money interact (including a poll that says, among other things, that husbands tended to underestimate “how much women care about almost every financial issue”). But possibly the more important thing you need to know about money and marriage is the simplest: that your marriage and your money need to be dealt with in the unique way you and your partner decide on, not based on other people’s stereotypes and outmoded cultural ideas.

Letting fear act on you

“Should we buy more angelfood cake mix?” I wondered as my husband and I walked down the aisles of our local Kroger. “It’s only up twenty cents.”

“I’m not buying beef jerky,” my husband said several aisles later. “I can’t stomach paying that much for that little.”

“Eggs are almost as bad as back in Seattle,” I noted further down the store.

“We’ll never again see 4-for-$10 deals on pop,” he predicted, not stopping in that aisle.

“Floss is cheap; I’m going to get two,” I said. Then realized that floss wasn’t food and, unlike everything else in the store, its price probably wasn’t going up.

Psychological studies have found that fear works as a motivator–but only when the fear is accompanied by a message on how to avoid danger. Take global climate change, for example. People who realize that it’s a real problem and may in fact lead to disaster down the road are generally panicked and depressed, because there aren’t any clear messages yet on how to fix things. (We’re getting there, though, slowly.)

In the current economy, people who are afraid of rising prices but can’t think of anything to do about them are likely to be paralyzed, afraid but unable to act. People who can think of things to do–use coupons, buy store brands, skip luxury items–are very likely to do them, and by doing do, mitigating their fears.

Fear can be a very useful persuasive tool. Letting it work on you can achieve big changes–just make sure they’re ones that are good for you, not good for the ones using the fear as a message.

Sunk costs don’t have to sink you

It’s finishing the $3 brownie that turned out to taste like chalk. It’s going to a Mahler concert, even though you hate Mahler, because you had season tickets to the symphony. It’s proposing to your girlfriend, even though you’re not sure you want to, because you’ve been together so long. It’s the sunk-cost fallacy, and chances are, you’ve been a victim of it.

The sunk-cost fallacy is the tendency of people to make decisions based on past costs and benefits rather than future ones. You’ve probably heard of throwing good money after bad: you’ve already put in this much time/money/whatever, and you don’t want to waste it, so you stay in a situation even though you’re not going to get anything out of it. Rationally, this doesn’t make a lot of sense; why put yourself into a situation that will yield nothing instead of making a better choice?

This recent study suggests that we do it more when we’re young. Strough, Mehta, McFall, and Schuller (Psychological Science, July 2008) asked young adults and senior citizens to evaluate how long they would watch a bad movie. Young adults said they would spend more time watching when the movie was one they had paid for, but the older adults chose to watch about the same length of time whether they had paid for it or not.

Strough et al. suggest that this is because older adults are more likely to look at positive aspects of situations, while younger adults pay more attention to negative aspects and therefore try to make up for their “lost investment.”

This argument may or may not hold water–personally, I find myself less likely to spend time doing any uncongenial activity as I get older–but the result is the same, no matter the reason: older adults are less likely to trap themselves in bad situations than younger ones.

This doesn’t mean that all we can do is wait to grow older. Larrick, Morgan, and Nisbett (Psychological Science, 1990) called the principle that we should be obeying–considering only future costs and benefits, not past actions, when making decisions–the sunk cost principle. They found that college students could easily be taught to apply this principle–a one-month checkup after a short training session found the students using it successfully. Essentially, the key is to treat whatever you’ve paid for–a movie ticket, a stock, a relationship–as if you hadn’t paid for it. Would you still want to keep it if it had been handed to you free that morning? If not, then it doesn’t make economic sense to spend any more money or time on it. We, too, can avoid sitting in the rain to watch baseball and keeping money in bad funds when all that’s motivating us is regret over a past investment that’s already irrevocably lost. Sometimes all it takes is a little knowledge.

Emotion can be the enemy

Apparently, movies are the next to go in airlines’ attempts to make up for rising fuel prices. US Airways will be removing movie service on its flights November 1, and expects to save some $10,000,000 a year by doing so. They have also decided to start charging for beverages. And, of course, they were among the first–though not the only–to institute charges for checked luggage.

My husband and I just got back from a trip from Toledo to Seattle. On the way back, we discussed the merits of driving instead. His family lives in Toledo, mine in Seattle, and the distance is about 2400 miles. Driving would take about three days. (It’s possible to do it in two, but only in good weather without much sleep.) It would be more comfortable and flexible, but more troublesome and expensive: three days’ travel instead of six hours, needing at least one of us to be alert for all that driving, paying for hotels and food and gas.

Until the recent announcements, we never seriously thought about driving instead of flying. But now we are. What changed? The ticket price and the smaller seats and the luggage charges, yes; but mainly, it’s the beverages. Currently, beverages aren’t allowed through security lines unless they’re less than 3 oz. Once drinks are no longer free, our options are to buy from the airport, to buy from the airplane, to go thirsty for five hours in the arid plane air, or finagle a drink–bring an empty bottle and fill it with tap water in the airport bathrooms, for example.

This is not a big grievance. So I have to carry a bottle with me, or pony up two dollars for a drink. Is that really worth the enormous hassle of spending three days in the car, paying for two hotel stays and some 75 gallons of gas each way?

Logically, no. But logic and money don’t necessarily have a lot to do with each other. Here, what’s pushing us to think about avoiding the airlines is resentment: that we’re losing privileges we had before, through no fault of our own, and paying the same amount (or more) money for the experience. We feel cheated. We feel annoyed. We don’t want to deal with the entity that’s depriving us of what we had. But financially speaking, putting up with the loss of privileges is worth it. Two round-trip plane tickets cost about $800; driving the same distance costs about $600 each way. Plus there’s the matter of those extra two days of traveling. Four days and $400 is worth the hassle once we stopped to work it out; but the cost of going with our emotions wasn’t readily apparent until we did.

This balance–between money and emotion, logic and comfort–is present in most financial decisions you make. It’s less evident in most, but your emotions color most of what you do. Emotions were evolved as mechanisms for enhancing our survival, but evolution hasn’t caught up to Wall Street yet. Emotion is a continual opponent in our struggle to do our best for ourselves financially. There’s no real cure for it; all you can do is be aware that your emotional self is not necessarily your best self to consult on money matters. This is not to say that happiness and comfort aren’t worth paying for; they are. Sometimes. The key is in deciding how much they’re worth in each situation and acknowledging that that’s exactly what you’re paying for.

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