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Tuesday, August 28, 2012

Dangers of Framing

We discussed the flaws in mental accounting and how it negatively impacts our financial decision-making process. A key fundamental flaw in mental accounting is the effect of framing.
Framing is how we tend to view our mental accounting decisions. For example say you go to the big box store and look at the newest in computer tablets and you find a tablet you like for $500 but remember that the discount store around the corner is selling the same tablet for $400. It is an easy decision to buy at the discount store and save $100. The next day you go shopping for a new bed, and you find the one you want for $3000, but the store around the corner is selling the same bedding for $2900 saving you $100. Yet this time you purchase the $3000 bedding. Why did you make this decision? It is due to framing, in each case you saved the same $100, yet your framing of the matter was based upon the rate of discount. The 20% discount was far greater in your mind then the approx. 3.0%discount for the bedding. The reality is in both cases you would have saved the same amount of money $100 but chose to ignore the $100 savings in the second circumstance.
The danger of framing is what your benchmarks are and if these reference points are consistently meaningful. If the reference point becomes tied to a discount you will consistently make poor decisions about money.
Investment psychology becomes even more important as these investment decisions have numerous variables that can be mismanaged through poor mental accounting. These mistakes with money are constantly made by the majority of investors.
Your financial decision-making process is the foundation to any investment success. In my private practice I had used an Insurance company who created a marketing campaign in which they would provide Susan B Anthony Silver Dollars for us to hand out on initial prospect interviews. The slogan was “Even the US Government makes mistakes with money.” (the Susan B Anthony was minted the same size as the quarter, and many people purchased $3 Cokes at the soda machines) Most prospects found this humorous until they were exposed to the reality of how their financial decision-making process was consistently causing them painful mistakes with money.
Your focus point is once again in your money journal. Reflect back on what your focus has been with regards to sales. What is the last item you bought on sale and what was the deciding factor. Identity these for small and large ticket items and see if the mental accounting bias of your framing has caused you a loss of money. Once you identify what are important reference points for you, an understanding of the framing process will be easy to identify.  This self-understanding of your specific financial decision-making process will be the first building block that needs to be in place before you can successfully insulate and inoculate you from scams, fraud and predatory sales tactics.

Tuesday, August 7, 2012

The Pitfall of Mental Accounting

The majority of investors have a bucket list when it comes to money. They separate money into buckets and prioritize those dollars usage. An example of this behavior is a college fund. When investor puts the dollars into the college fund they lock it up and wouldn’t consider any other usage of those dollars, even if those dollars were being eroded by inflation they would stay in the college fund bucket. This is commonly referred to as mental accounting.

Mental accounting creates a disconnect with the big picture overview for financial decision making. We are much more likely to take risk with money perceived to be “house money” as is witnessed by the casino behavior with winnings. By example, when we go to the craps table with $100 and win an additional $200, we are more likely to take a bigger risk with that $200 then we would if the money was our own to begin with. The perception is that the money isn’t really ours and we didn’t work to earn it so we can risk it with impunity.

Where this disconnect displays itself best however is with tax returns. Our tax return represents money that we worked for and earned yet we ultimately perceive it as found money and are willing to frivolously spent or risk it. It is not the same circumstance as the casino effect but it is the same result.

So how does mental accounting endanger an investor as a potential victim? The psychological trigger used by scammers is a twist in the mental accounting behavior practiced by individuals. The twist is in the offer of tremendous gains, when triggered the individual reverses the fear of loss to the gain and not their initial investment. The mental accounting fast forwards to the gain and sees it as the risk involved. When the con explains how you will earn 3 million dollars on the upside, he has triggered your mental accounting to the gain. Now the impact of investing $100K seems very reasonable and the fear of loss is focused upon $3 million. The sense of urgency is created and the initiation of personal greed has blinded the victim from the real fear of loss which should be focused on the $100K being risked. This twist of mental accounting is one of the common triggers used in scams, fraud and predatory sales tactics.

The take away here is that money is always just money. It doesn’t come in separate categories such as found, house or risk free. It is a financial means to an end and has stated value. The opportunity to increase and multiply through risk is a transactional event that needs to be fully vetted for due diligence and risk analysis. In the end though the money requires no mental accounting.

Friday, August 3, 2012

The Power of Confirmation Bias

A resulting impact from anchoring and overconfidence is an additional form of bias referred to as confirmation bias. This bias puts us at risk in the way we perceive information. We continually extrapolate our own beliefs unconsciously and treat information that supports what we believe or want to believe more favorably.

During the decision making process for financial decisions we will refer to information that supports our decision more favorably. We rarely give the obvious negative much consideration. This is due to confirmation bias.

Sales predators are well aware of how individual biases will impact an individual’s decision making process. Surely you have sat through many sales presentations and have not picked up on the unconscious (subliminal) messages. These messages go right to you core belief system and trigger your confirmation bias. You unconsciously are seeking information that supports your beliefs and desires. Unfortunately common sense often is over ridden in this process.

For example you may have a favorite industrial sector you has been very good to you over a period of time. Let’s say energy for example. You will be much more inclined to believe information that supports you positive experiences in this sector and disregard any contrary information. In essence you will continually discount any negative information that could well make a difference in your decision making process.

Hindsight also plays a predominant factor in a confirmation bias. This creates a tendency to re-valuate our past behavior surrounding the decision after we have full awareness of the outcome. Our judgment of a previous decision is tainted by a bias formed to accommodate the new information. In a stock investment once we know the outcome of the stock’s performance we adjust our reasoning for purchasing in the first place. When updating our rationalization in this manner prohibits us from viewing past decisions as objectively as we need to.

The focus effort required here is to once again journal your experiences as they pertain to your decision making process. In order to recognize your internal biases you must have data to review. Without this data you will continue to groove ruts in your decision making process. We become creatures of habits in our decisions. By having a record of the thought process and emotions involved in any decision you will be able to review results with clarity and full transparency. By treating all information with full objectivity you will not fall victim to confirmation bias in your decisions.

Next time we will cover the disastrous impact of procrastination.