Carnival Update

Over the last week I've been included in a pair of quality carnivals. The first is the Carnival of Real Estate hosted by Searchlight Crusade. The editor disagreed with my recreational approach to real estate I called House Lust. I agree that it can be dangerous, but if you are conscientious I think cruising the open house circuit can still be an informative and fun way to spend a pretty weekend.

One of my articles was also included in the Carnival of Ethics, Values, and Personal Finance. I've always thought it is important to recognize that personal finance is much less about numbers and more about our values, goals, and aspirations. Check out the carnival for some great reading.

One last thing I want to include in today's round up is the creation of a new category of post on Aspire 2 Wealth. Recently I've written two posts on the topic of Behavioral Finance. I am a big fan of this area of research and so over the next few weeks and months I will hopefully continue to cover more aspects of this neat (financially powerful) science. Check out Your Brain Make Building Wealth Hard and More Ways Your Brain Tricks You if you missed them the first time.

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More Ways Your Brain Tricks You

Today I came across a great article about more ways your brain tricks you into making bad financial decisions.  The article, Why You're a Big Sucker, explains how a few blind spots in cause us to make bad consumer decisions and cost us money.

Two examples resonated with me personally.  The first is how the word FREE tricks us into doing some very stupid things.  In short, when a marketer or sales person is giving you something for free there is always a catch.  In my case, I called a toll free number advertised on the radio to collect my "free" trip to Las Vegas.  Of course, I found out when the marketing materials arrived there was indeed a free trip, except for the $29.99 handling fee, the $79.99 conditional cancellation fee, and the mandatory 2 hour time share presentation.  Oh, I also forgot that my wife and I could only collect our plane tickets if we were flying from a designated airport (all on the West coast) or were willing to pay a $200 travel destination upgrade to allow us to fly out of Atlanta (still a 3.5 hour drive from our house).  I also learned that by giving out my person information I landed myself on direct mailing list for every scam under the sun; I was a big sucker.

The next example that hit home is the idea that prices are relative to your surroundings.  When I am in Best Buy looking at televisions, the $1,500 42" LCD TV seems like an absolute bargain when it is put up next to the $2,700 50" LCD and the $3,300 55" Plasma.  A sneaky merchant will add a moderately priced set into a lineup of pricey sets and then tack on a "free bonus."  Of course, $1,500 for a TV is a lot more expensive when considered in a vacuum, but when it is sitting next to a whole row of more expensive options it can seem like a great deal.  Amusement park food also comes to mind when I think about the relative cost of available options.  When it costs $8 for a hamburger and $4 for a 20oz Coke a frugal person will pick the $4 hot dog and a $2 bottled water.  The situation has induced you to spend way too much money, but still get the illusion of being responsible with your money.  In other words, be sure to keep costs in their true perspective and keep the situational bias at bay.

I am regularly fascinated with the ideas behind Behavioral Finance.  A few days ago I wrote another article on the topic that you should check out as well titled, Your Brain Makes Building Wealth Hard.  Thanks for reading.

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Your Brain Makes Building Wealth Hard

One of the first steps to overcoming a challenge is to recognize there is a problem. If you do not know where your stumbling blocks lie it is often impossible to achieve the results you desire. In the wealth building process there are multiple challenges, but one that many people don't recognize is your own brain. Our brains developed to do a great job helping us hunt, gather, and reproduce. Unfortunately our brains are not particularly suited to the challenges of creating wealth.

There is [relatively speaking] a new field of study called Behavioral Finance. The basic idea is that investing decisions are made by people, and people are influenced by psychology in addition to the pure numbers of the markets. In fact, investors (being human) are subject to quarks of neurology, biochemistry, and evolutionary anthropology which in turn influence all of our money decisions.

So, now that we realize that there is more to investing than just the numbers, what does that mean? First off, it means that your brain is not always aligned with your aspiration to build wealth. In many cases your brain can drive you to do the wrong thing with staggering regularity. The best example is the tendency to sell your investments (in panic) during a market downturn.

Everyone knows that to make money a person must "buy low, sell high" but in practice most investors jump on the bandwagon when the market seems to go up, up, up and then sell to stop the pain as the market falls. What is the result? The average investor buys stocks when they have already gone way up and sells after they have dropped. This is a "sell low, buy high" strategy that will loose money every time. Why then do some many people follow this pattern?

The short answer is people "feel" the pain of a loss in the market much more strongly than they "feel" the joy of a gain in the market. Think about this, if you have saved a nest egg of $200,000 which would effect your emotions more, gaining $20,000 or loosing $20,000. The vast majority of people are more emotionally impacted by the loss. In order to stop the pain, they sell the stock. This effect is call Myopic Loss Aversion and has been studied and documented in the majority of people, professionals and amateurs alike.

Behavioral finance relates to several other important ways in which your brain sabotages your finances. It has uncovered important data about why people have such a difficult time saving, budgeting, and investing for the long term. It turns out we are nearly all subject to a Stone Age era inability to evaluate the benefits of long term returns versus instant gratification.

Centuries ago it was much better to have a bird in hand (to eat tonight) than to wait a few weeks or months to be able to eat two birds. If you starved now, doubling your "investment" isn't worth anything (you'd be dead). This is one key reason our instincts fail us when it comes to evaluating market returns. Market bubbles and crashes are another example of psychology creeping into our investing reasoning (and reaping havoc).

In other words, behavioral finance has some impact on nearly all aspects of our financial lives. Now that we know there is a problem, lets do what we can to create wealth for ourselves in spite of our brain.

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