Even smart people can make big money mistakes

When I was at the graduate school of economics at UCLA in the 1980s, I recall sitting in the back of a classroom diligently scribbling down everything that the oracle - er, I mean professor - spoke. The classical theory of economics rests on some simplifying assumptions. Chief among these assumptions is the one that all individuals in an economy act in a perfectly rational way at all times. We are assumed to make decisions that perfectly anticipate all future outcomes. The theory blesses us with astonishing powers of foresight and calculation. If chess was economics, we would know in advance every move that both we and our opponent were going to make over the future course of the match.

So, along with recalling all of this theory, I also recall having one particular thought: Do you guys actually believe this stuff?

If you buy into these classic assumptions, then financial bubbles do not exist. All stocks are priced fairly at all times. None of us ever makes a serious money mistake. The market never crashes - unless we know in advance that it was about to.

Over the past two decades, a branch of economics called behavioral economics has risen in prominence. This rise culminated in the awarding of the 2002 Nobel Prize to two pioneers of behavioral economics - Daniel Kahneman and Vernon L. Smith. These two recognized that we are not the omniscient super-computers imagined in classical economic theory. We make mistakes regularly, and we make lots of them.

Behavioral economists translate natural human tendencies about decisions of all kinds to financial matters. I cannot give a full overview of the major categories here, but one that I see often among investors is called the "confirmation bias." Both pros and do-it-yourselfers make this mistake. The confirmation bias consists of a tendency to look for, favor, and be overly influenced by information that confirms your initial hunch. A related error is anchoring, in which the first number or piece of information you see illogically forms your initial hunch.

An example of anchoring is when an investor reads an article that gold rose 25 percent last year. That number is now stuck in the investor's head, and all future analysis of potential returns on gold is drawn toward that number. Further, the investor might begin to interpret all information about gold's investment potential as supporting the notion that gold will return 25 percent. After I wrote a column about commodities a while back, I received a few e-mails from readers that were absolutely passionate about the fact that gold will produce huge returns indefinitely into the future. They provided me with extensive, albeit flawed, analysis and evidence supporting this notion. This is anchoring and the confirmation bias in action.

The confirmation bias can be particularly damaging to consumers. Brand loyalty is a common example of the bias. A Cornell marketing professor found that people who replace their car with another model of the same brand pay more than what other consumers pay. A lot more. He found that loyal Mercedes customers paid $7,410 more on average for a new Mercedes than did buyers switching to Mercedes from another brand. Existing Mercedes buyers hold such a powerful confirmation bias about the brand that they pay thousands more for the car than do people that shop around first.

In my own practice, I see the anchoring and confirmation bias all the time. I might mention to a visitor that stocks have returned about 11 percent over the past two decades, and then ask what they think stocks will pay in the future. They generally pick a number close to 11 percent. If I instead mention that stocks have returned about 7 percent over the past 100 years, and then ask what they think about the future, they will suggest a number close to 7 percent. The punch line here, of course, is that future stock returns have nothing to do with past stock returns. They have to do with current prices and future earnings.

Salesmen and marketers know all about the confirmation bias and anchoring. In the financial marketplace, these effects are used to steer your thinking toward a decision that is profitable to the brokerage house. You can increase your odds of avoiding this trap by gathering information from several sources before making big money decisions. Do your research and form your own independent judgment about important expectations. Finally, be realistic. Have a longer memory than last month's mutual fund advertisements. Pay attention to actual current conditions. You might not be the supercomputing human I learned about in graduate school, but you are smart enough to make your own decisions.

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