Three mistakes smart people make that you can avoid

If you are anything like most people, it is likely that you think of yourself through rose-colored glasses of optimism: We often think that we are less at risk of making mistakes, bad things are not as likely to happen to us, and even that we might be smarter than most people. While these things may not be true for everyone (because we can’t all be above average!), what we do know from decades of psychological research is that smart people make mistakes too, especially when it comes to managing our long-term finances. Here are three common mistakes smart people make that you can avoid.

 

1. We are impatient and make decisions that provide instant gratification

It’s New Year’s Eve, and your resolution is decided: This year, you will finally pay off your debts and save for retirement. New Year’s resolutions are easy to make, because in the future we are all great people with perfect self-control. However, come February you might be tempted to put that nice suit you found on sale on your credit card. This behavior is familiar to behavioral economists, as it is symptomatic of what we call “present bias”. Present bias, or hyperbolic discounting, is the tendency to favor immediate rewards at the expense of our long-term goals.

So if it’s going to be tempting to spend our money on what seems the most exciting or useful in the present, how can we ensure that we don’t give in to temptation? Traditionally, higher interest rates have been used as an incentive to encourage saving. Because this doesn’t always work as well as we’d hope, behavioral economists have found other methods to help us stick to our plans.

  • Adding a social element: In a large two-year study conducted in Chile, a team of researchers headed by Felipe Kast tested the effect on savings of weekly self-help peer groups, text message reminders and the more traditional approach of a high interest account that paid 5% (instead of 0.3%). They found that even the steep increase in interest did not significantly change how much people saved. On the other hand, those who were in the peer group deposited money as much as 3.5 times more often! The text message reminder also worked very well, getting people who were using it to deposit almost as many times as those in the peer group. This is great news, as it’s easy to emulate in our own lives: We can tell a friend about our goals and ask them to keep us accountable, or we can use an app reminding us to save.
  • Committing to saving: If you know that saving will be a struggle, using something called a “commitment device” might be for you. Don’t let the device-part scare you, all it does is that it lets you make it more difficult for your future self to give in to temptation! One way to start is by setting aside money in an account that you can only access at a certain time or for a specific purpose. To make it even harder to access your new savings account, remove online access so that you have to physically go to the bank to access your savings.

 

2. We hate to admit that we have wasted resources

What does divorce have in common with investments? They may seem worlds apart, but the answer is the sunk cost fallacy. Have you ever had a friend hesitant to get out of a relationship that is clearly toxic, yet they insist on staying because they have invested so much of their time and emotional energy into it? It turns out we think similarly about stocks we have invested in when they are underperforming. Imagine spending $2000 on the stock of a new company in January. By the end of the year, your stock has dropped all the way down to $100, despite similar companies and the market doing well overall. Because we are reluctant to admit that we have wasted resources on a past decision, we tend to stay the course or even invest more resources to make our initial decision seem worthwhile. So instead of taking the $100 we have left and invest in other stocks, we leave it until it is essentially worthless.

The important thing to notice with this example is that the takeaway is not necessarily that we should sell any stock the moment it starts to perform badly. Markets fluctuate, and that means that there will be natural ups and downs. However, if the market is performing well, similar companies are doing well, but your stocks are underperforming, it may be time to cut your losses. Another solution would be to decide ahead of time how much risk you are comfortable with, and sticking with that decision. For example, if a stock has underperformed every month for X months, I will sell it.

 

3. We don’t track our credit and spending

Have you ever been so worried about how much is in your bank account, yet you dread checking it so much that you don’t do it? This is called the Ostrich Effect. Much like an ostrich hiding its head in the sand, we can go to great lengths to avoid getting bad news. This is reflected in how often the average American check their accounts: In a 2012 survey by the American Institute of Certified Public Accountants, researchers found that only between 14-17% of those surveyed checked their bank accounts daily. About a quarter of adults with a high school education never checked their bank accounts at all! The number of people keeping an eye on retirement accounts was similar, with four in ten adults reporting that they never check their balance.

Because of the common misconception that checking your credit it bad for your score, the statistics for people monitoring their credit are not looking any better. In fact, research by the Consumer Financial Protection Bureau (CFPB) found that just 16 million Americans, (8% of the adult population) obtained their credit report between 2010-2011. According to a large 2015 survey by Credit.com, 26% of those who didn’t check their credit said that they didn’t think it was important to them, and 13% were afraid to see their credit reports.
To avoid making the mistake of not managing your finances, make it a habit to check regularly. With tools like online banking, Creditkarma and apps like Mint, tracking our financial behaviors are easier than ever. Checking your credit score will only serve you well, and monitoring your progress over time will give you more insight into what’s affecting your credit and spending.

 

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