Today is day two of Continuing Financial Education (CFE) week here at The White Coat Investor. Personal Finance is both finance (math) and personal (behavior.) Your initial financial education should consist of becoming familiar with both of these important topics, so I always recommend a book on behavioral finance. I get sent a lot of books throughout the year (and when authors see I do books reviews from time to time like this week, I'll be sent even more.) I almost always read at least part of the books I'm sent, but I don't review them all on the site. I just prefer not to let other people dictate how I spend my limited reading time nor my limited time and effort to write blog posts. Of all the books I was sent this year, this is one of the few I'm going to highlight during CFE week.
The Foolish Corner is a short (110 pages, double-spaced) behavioral finance book subtitled, “Avoiding Mind Traps in Personal Finance Decisions.” It is not my favorite behavioral finance book, (you can find those on my recommended book list) but the best book for many people is the book they can get through. And everyone can get through this book. Heck, my daughter Whitney read more than half of it on a drive across town coming home from her brother's hockey game.
The book is written by John Howe and Rob Corrigan. Howe is an academic, the chair of the Department of Finance at the University of Missouri. Corrigan is a marketing consultant with a lot of experience in financial firms and start-ups. Their book is refreshing in its brevity and clarity. The whole thing is high-yield and well worth your time and money.
It goes through 27 different behavioral finance traps and concepts over the course of 10 chapters, and even provides a helpful table at the end summarizing them all. I won't reproduce the whole table (it's probably more information that is really covered under the “fair use” laws,) but I'll list all of them below with a brief explanation. If you don't know what all of these are, you should read the book.
- Hedonic adaptation – The exciting becomes ordinary and boring
- Hedonic treadmill – Running after an ever moving target without increasing happiness
- Money illusion – Focusing on the number of dollars you have instead of what they can be traded for
- Individual purchasing power – Your cost of living (and its increase with inflation) is different from everyone else's
- Odd-even pricing – Thinking $19.99 is significantly less than $20.00
- Pretax pricing – Not including sales tax when looking at a price
- Currency adjustment – Foreign currency may not seem as real as domestic currency so you value it less
- Credit cards vs cash – Easier to spend using a credit card than cash
- Myopic loss aversion – Losing money is painful, so we make irrational, short-term decisions to avoid pain
- Prospect theory – The pain of loss exceeds the pleasure of gain of the same magnitude
- Pattern recognition – Fooling ourselves into seeing a pattern when there is no actual pattern
- Hot-hand phenomenon – The belief that streaks will continue longer than they do
- Affect bias – Focusing on an irrelevant characteristic of an asset
- Overconfidence – Confidence beyond what is justified by the facts
- Optimism – People with a positive outlook are happier
- Level of savings – Failure to save enough
- Sense of inadequacy – Head in the sand about the importance of savings
- Evolutionary myopia – Evolutionarily speaking, humans don't make short-term sacrifice for long-term gain
- Framing – Your point of view affects your behavior
- Sunk cost – Focusing on irretrievable past expenses rather than future prospects of an investment
- Opportunity cost – Ignoring what else you could do with your time or money
- Marginal cost – Focus on what happens “at the margin” when making decisions- like marginal tax rate
- Confirmation bias – Greater acceptance of information that supports your belief
- Availability bias – Easily available evidence gets more weight in making a decision
- Recency bias – Paying too much attention to what happened in the recent past
- Familiarity bias – Paying too much attention to evidence that is more familiar
As you can see, there is a lot to understand about investor behavior and forewarned is forearmed. The book not only describes these errors in thinking, but also teaches you how to avoid making them. Here's an example:
Money illusion…arises when we confuse the physical aspect of money itself with its actual “purchasing power,” its capacity to be exchanged for goods and services. Another way that economists put it is that money illusion is the confusion of nominal value (the face value or number of dollars stated on the physical piece of paper) with real value…money illusion is akin to mistaking a menu for the food itself.
Why does this happen? Primarily because people don't properly take inflation into account….People mistake the nominal increase in the value of their house for an increase in real wealth…Believing that they are truly wealthier, they shift toward less saving and more spending. Even more dangerously, they may borrow against the increased house value….Should the value decline, as happened in the financial crisis of 2008, they find themselves owing more than the house is worth.
Buy The Foolish Corner today!
What do you think? Have you read The Foolish Corner? Did you like it? What is your favorite behavioral finance book and why? Which of these behavioral mistakes do you see your peers making? Comment below!