WE ALL MAKE FINANCIAL mistakes, and they add up.
Consider: From 1986 to 2005, the Standard & Poor's 500 returned 12% annually, but thanks to overzealous trading, the average investor in stock mutual funds made just 4%, according to Dalbar, a Boston-based financial-services research firm. Homeowners pay high insurance premiums to keep deductibles low, but only 7% report claims each year. And 74% of Americans overpaid their taxes in 2005 — essentially giving the government an interest-free loan.
Why? A developing discipline known as behavioral economics seeks to answer that question, but it boils down to this: Academic research tells us that emotions and experiences can distort our financial decisions. While our mistakes are rarely the result of a single mental error, our feelings can make us fumble. Below, seven big financial mistakes and the psychology behind them.
#1 Saving with the right hand and spending with the left
DIAGNOSIS: Mental accounting
SYMPTOMS: Keeping a savings account that pays 5% interest while paying Visa 15%; thinking a tax refund equals mad money; obsessing over the price of a new car, but failing to monitor the weekly grocery bill.
Another way to think of "mental accounting" is separating money into buckets, each with a different purpose. It's not always a mistake — it is the premise behind budgeting, for example — but looking at your finances in parts without seeing the whole picture can hide costs and charges you could otherwise avoid. Consider a $5,000 tax refund. Woo-hoo! Right? Wrong. If you put your overpayments in a high-interest savings account throughout the year, you would net about $135 in interest instead of giving an interest-free loan to Uncle Sam.
#2 Playing it too safe
DIAGNOSIS: Loss aversion
SYMPTOMS: Quick to sell winning stocks but slow to sell losing ones; putting too much cash in money-market funds and not enough in stocks; reluctance to trade away what you already have, even for something more valuable.
No one likes losing money — a truism that economists call "loss aversion." Because we can avoid only losses that we recognize, we tend to focus on immediate costs, while ignoring more subtle costs and even savings. For example, we should recognize that getting a $4 discount is worth as much as avoiding a $4 surcharge. But most of us would rather avoid that surcharge. By being "loss averse," investors open the door to a more insidious cost, the toll that inflation will take on their savings."