Mental accounting. Let's say you get a big tax refund or win big at the weekly poker game. Despite the fact that you're heavily in debt, you see the windfall as "free money" that you can spend frivolously without any impact on your complete financial picture. But money is "fungible," so a dollar you find in the street is no different than a dollar you earn at work.
Likewise, we're prone to hold money in savings or other accounts that pay negligible interest rates while servicing debt that charges higher interest rates, thinking of these balances as somehow different. But the net loss on interest dictates that you'd be better off paying down the debt.
[See Investors: Please Behave Yourselves.]
Herding. Dalbar defines this as "copying the behavior of others even in the face of unfavorable outcomes." Herding is most clearly on display during market panics, when everyone sells because everyone is selling. Rationally, though, that's the precise moment when we should be buying. Herding occurs when markets are rising, too: People buy what they see others buying for fear of being left behind, even when prices are looking unsustainable. We tend to think that there is safety in numbers, and some of us may fear losing on our own more than we do losing along with everyone else. If the crowd leads us to failure, we aren't solely to blame.
Media response. We naturally tend to overreact to headlines when we lack the information necessary to put things into contexts. "Hang Seng Index Plunges 200 Points" sounds alarming if you don't know that the index is currently around 20,000 and that 200 points is only a 1 percent move, not all that much in this era of volatility. Likewise, "Jobless Claims Fall by 10,000" sounds encouraging if you don't know that analysts were expecting a fall of 12,000. Any advertiser knows that there's power in what's known as the fallacy of suppressed information. "5,000 dentists recommend Dazzletine" sounds impressive only if you don't know that 10,000 dentists say don't buy Dazzletine.
Whoever said "what you don't know can't hurt you" probably didn't get rich in the stock market.
Reader Comments (