Cognitive Dissonance and Finance
Disclaimer: This entry isn't really about technology.
It never ceases to amaze me how people believe what they want to believe. Some ideas get so ingrained into people's heads that no matter how much evidence you show that they are false, they will just continue to believe what they want. It's been said that mankind is a rationalizing being, rather than a rational being - and nowhere is this more true than in the world of finance.
I had two stints in undergraduate college. The first was a regular traditional daytime program, and the second was also fulltime, but held on the weekends. The people in the second program sometimes made me wonder. My MBA program wasn't a lot better in this respect.
There are all sorts of documented logical flaws that people are susceptible to, and they have been well demonstrated - however I would hope that learning about them would make people at least a little immune. As they say, "you can lead a horse to water..."
About half way through my finance degree, after we had learned that a good company doesn't necessarily mean a good company, and other things that laypeople could be forgiven for not understanding, we had a project where everyone had to come up with a method of deciding what stocks they would by. To simplify, my analysis essentially took the fact that there is no reliable way to predict the market, and consisted of buying into index funds, etc., altering certain ratios depending upon how much risk one was willing to take, and how long they were willing to be without the money. Most importantly, I was proud that it was logically and mathematically sound. To be sure, since the market is unpredictable, someone could have followed my strategy and lost money, but there was a logical underpinning, and they would have been far more like likely to increase their wealth over any time span longer than the business cycle. Other people had plans of varying quality, but most of the people at least demonstrated that they had learned the concepts in the text book. One mathematically challenged girl, however, stood up and said "I would buy the stock of the stores I shop at, especially if they were busy. If they are busy, they must be selling a lot." Great, it sounds similar to the strategy of one famous mutual fund manager. Except his strategy wasn't really that simple. The professor was silent for a minute, and then said "... questions? comments?" I asked the poor girl, "What if they were losing money on every sale? They could be busy because they underpriced their merchandise." She looked at me the same way a cow looks at an oncoming train. She hadn't considered that good for consumers doesn't equal good for investors. Of course, it could also have been that they were very profitable, but investors had already bid the stock price up to above what it was worth in an unrealistic expectation that the trend would continue. On the other hand, you could have a store with very low traffic, but a very high profit margin. The point is, you can't even begin to guess without some analysis.
In fact, it occurs to me that a lot of people don't understand the basic difference between revenue and profits, nor do they understand that things have to be analyzed as percentages. Every time someone says "Those fat cats at company xyz are making billions!", it makes me cringe. First of all, if they have a revenue of billions of dollars, that doesn't matter, that matters is how much they keep. Some of the industries with the highest revenues have the lowest profit margins. Second of all, say IBM made $10 million in profits last year - if they have 10 million investors, they only made $1 each. (Before taxes!) If they bought their stock for $100, then they only made 1%. They could have done better in their checking account. This is something that you shouldn't have to be a finance major to figure out.
Another well established behavior pattern is that people tend to be very bad at statistics. We tend to over-react to vivid one time events, and under-react to "boring" normal data. For example, the 9-11 attacks made people scared, even though most people are much, much more likely to die in a traffic accident. People see traffic accidents every day, so they are "ok" with that risk. In another project for my finance program, we had to come up with a retirement plan. The topic of average income came up, and so I looked up the average (mean) salary of a graduate from an accredited 4 year school at the time, which was around $50,000. This statistic was compiled by the government and some educational agencies, composed of many thousand data points, and vetted by professional statisticians - but one girl in my group refused to believe it. "That's way too high!", she exclaimed indignantly. I asked her why she thought so, and she said "Well I know this one girl who graduated in social science..." Ok, so she knows one girl who graduated from a particularly low-paying major, and... that trumps a huge mountain of professionally culled data? She took statistics class too, so she should have known better. In fact I asked her "Ok, how many samples should you have to get a 95% confidence level if there are say, 100,000 college graduates in the US?" Again, the deer in the headlights look. I don't expect everyone to memorize every formula, but they should at least remember the concepts, so they should remember what to do and where to look up the formulas. She had no idea what I was talking about. I eventually calculated it for her, after showing her the formula in the statistics book we had used a few terms ago. As you can probably guess, the required sample was much larger than one person. Even without doing the math, she should recognize that "a girl she knows" is not valid data.
(In case you're wondering, I am not picking on females, the majority of the people in my finance program were female.)
Later, in my MBA program, after we discussed "sunk costs" in our accounting class, we had another class. We had to weigh options, and sure enough, one of the girls said "I would choose this option because it would be ashamed to waste all the effort and money already sunk into it." Doh! It seems like people can remember things to pass the test, but forget about actually understanding and applying them. I talked with her after class, and it turned out that she had never really understood the concept, even though she knew the right answer when it was directly asked. I explained it to her like this "Say you have put $5000 into fixing your car over the years, but it broke again last week. Fixing it would cost another $5000. Or, you can buy a new one for $4000." She looked at me and said "Why would I spend $5000 to fix a junker when I could get a new one for $4000 - ooooohhh I see...." Exactly.
If these kinds of problems were limited to the classroom, it would be mostly harmless, but unfortunately they are not.
One person at my old company came to me to ask advice on whether they should buy into the employee stock purchase plan. I told them that depended on whether they were comfortable with the risk. "Well I already own $5,000 worth", he said. I asked him when he had purchased the stock, and he said "oh, about 5 years ago." The vesting period was only two years, so he was eligible to sell the stock he had. I told him "Ok, here's what you should do. Even you don't want any more stock, but you are comfortable owning what you have: Sell $2,000 worth, and buy $2,000 more." By doing this, he would make a profit on the original stock he had purchased, and get a 20% discount on the new $2,000 worth - while keeping the same position. "I don't know... that seems complicated.", he told me. One couldn't ask for a better deal. (The only disadvantage to the deal would be that he would have to hold the new stock for 2 years from the date of purchase, and he wasn't planning to sell his stock anyway).
One of my friend's parents came to visit her while we were in college. They knew I was a finance major, so told me that they were planning to invest a lot of money into a single telecommunications company and asked me what I thought. I told them that putting a large sum of money into the stock of a single company was more akin to gambling than investing. They disagreed and told me it wasn't gambling because they were certain the company was solid - although they admitted that they hadn't done any research on the company, and were relying on a "tip" from a friend. About a year later my friend sheepishly told me that her parents had lost most of the money they put into that company - and the market was up from the point when they invested.
More to the point, everyone seems to think they know everything there is to know about investing, without having taken a single course in finance. Everyone always tells you how much they made on stocks, while nobody ever tells you how much they lost. One particularly noisy fellow was bragging to me at lunch one day, and so I called his bluff and said "Ok, if you want to brag, go home and print out all your stock purchase and sale history for the past 5 years and I'll check it out." Needless to say, such evidence never appeared. I don't think people are purposely lying either, they just happily remember gains while rationalizing losses away. Any way around it, though, nobody is going to make a living by day trading unless they are exceedingly lucky, or are trading on illegal information. Even if they were right 51% of the time (which over the long term would mean they were luckier or smarter than average), the brokerage fees and taxes would eat their returns up. This doesn't mean that the average investor is dumb, just that it's exceedingly hard to immagine them competing with the professional investors - and even they have a hard time turning a profit.
Many times, people have an attitude similar to the girl in my finance class, saying things like "Well I know Google is a good company..." - but they don't understand that such things may already be priced into the stock. Explaining the dividend discount model is a bit much for some people, so I explained it to one guy this way:
Me: "Ok, a Hershey bar is worth $1, right? and a Godiva bar is worth more, but how much is it worth?"
Guy: "Maybe $2?"
Me: "Right, because it's better somehow. But is it worth $20?"
Guy: "No way."
Me: "So we both agreed that it's better, but it's not worth $20 - why not?"
Guy: "Because, it's not *that* much better - it's not a good deal at $20. - ooooh"
Right, IBM or Google might be great companies, but they might or might not be worth their current stock prices. There is a difference between a good company and a good deal.
In general I find this theme repeating itself, people find it difficult to evaluate things like stock because they aren't so familiar with purchasing stock as they are DVD players or candy bars. Yet, at the same time, people who would spend their entire weekend doing research and checking out to different stores to get the best deal on a DVD player think nothing of spending thousands of dollars on stock that they don't understand.
Another person I know told me that they needed to save up some money, and they would need to spend it in two years - after which they asked me which stocks they should invest in. On the one hand, the market trends up, so if they had "extra" money they were willing to risk, they would be better off putting it in the market than not - but on the other hand, if the needed the money in two years, it makes little sense to put it in the stock market at all.
I'm not going to say they should have to learn all about finance or hire an expensive financial advisor, but at least they should know two things:
1. Investing in index funds is the safest thing to do in the stock world
2. If you need your money soon and/or aren't willing to risk losing some (or even all) of what you put in, don't buy stocks.
The magical value or property
In the mid 2000s, I knew a bunch of people who were really gung-ho about buying houses. Again, people came to me to ask what I thought. (It's been my experience that when people ask me what I think, they really want me to just validate their existing plans.) I explained that I wasn't an expert in property, but I would do a little research. The results were basically that property values in the US go up and down, but on average they tend to go up by an average of a little over 1% per year in the long term. (Also, they go up and down in different regions at different times, not always at the same time). I told them that buying could be better or worse than renting, depending on the property taxes, insurance, and mainly upon the interest and real estate agent fees. Mainly, I doused their enthusiasm by saying "You shouldn't expect your property to double in a year or something, it goes up 1% on average." Of course, looking at the actual data is a downer, so people preferred anecdotes that supported their proposed action: "Well my friend Bob just doubled his money in two years!" Well, ok, I'm not going to stop anyone. Then the bubble popped in 2008. So much for "Housing prices never go down." Seriously though, the same people who would comparison shop for their laptop can't be bothered to look at publicly available government statistics on housing prices.
Speaking of bubbles, it can be difficult to tell when you're in a bubble, and very difficult to tell when the bubble will pop - but sometimes it doesn't take a rocket scientist to figure out when a bubble is happening:
It never ceases to amaze me how people believe what they want to believe. Some ideas get so ingrained into people's heads that no matter how much evidence you show that they are false, they will just continue to believe what they want. It's been said that mankind is a rationalizing being, rather than a rational being - and nowhere is this more true than in the world of finance.
I had two stints in undergraduate college. The first was a regular traditional daytime program, and the second was also fulltime, but held on the weekends. The people in the second program sometimes made me wonder. My MBA program wasn't a lot better in this respect.
There are all sorts of documented logical flaws that people are susceptible to, and they have been well demonstrated - however I would hope that learning about them would make people at least a little immune. As they say, "you can lead a horse to water..."
About half way through my finance degree, after we had learned that a good company doesn't necessarily mean a good company, and other things that laypeople could be forgiven for not understanding, we had a project where everyone had to come up with a method of deciding what stocks they would by. To simplify, my analysis essentially took the fact that there is no reliable way to predict the market, and consisted of buying into index funds, etc., altering certain ratios depending upon how much risk one was willing to take, and how long they were willing to be without the money. Most importantly, I was proud that it was logically and mathematically sound. To be sure, since the market is unpredictable, someone could have followed my strategy and lost money, but there was a logical underpinning, and they would have been far more like likely to increase their wealth over any time span longer than the business cycle. Other people had plans of varying quality, but most of the people at least demonstrated that they had learned the concepts in the text book. One mathematically challenged girl, however, stood up and said "I would buy the stock of the stores I shop at, especially if they were busy. If they are busy, they must be selling a lot." Great, it sounds similar to the strategy of one famous mutual fund manager. Except his strategy wasn't really that simple. The professor was silent for a minute, and then said "... questions? comments?" I asked the poor girl, "What if they were losing money on every sale? They could be busy because they underpriced their merchandise." She looked at me the same way a cow looks at an oncoming train. She hadn't considered that good for consumers doesn't equal good for investors. Of course, it could also have been that they were very profitable, but investors had already bid the stock price up to above what it was worth in an unrealistic expectation that the trend would continue. On the other hand, you could have a store with very low traffic, but a very high profit margin. The point is, you can't even begin to guess without some analysis.
In fact, it occurs to me that a lot of people don't understand the basic difference between revenue and profits, nor do they understand that things have to be analyzed as percentages. Every time someone says "Those fat cats at company xyz are making billions!", it makes me cringe. First of all, if they have a revenue of billions of dollars, that doesn't matter, that matters is how much they keep. Some of the industries with the highest revenues have the lowest profit margins. Second of all, say IBM made $10 million in profits last year - if they have 10 million investors, they only made $1 each. (Before taxes!) If they bought their stock for $100, then they only made 1%. They could have done better in their checking account. This is something that you shouldn't have to be a finance major to figure out.
Another well established behavior pattern is that people tend to be very bad at statistics. We tend to over-react to vivid one time events, and under-react to "boring" normal data. For example, the 9-11 attacks made people scared, even though most people are much, much more likely to die in a traffic accident. People see traffic accidents every day, so they are "ok" with that risk. In another project for my finance program, we had to come up with a retirement plan. The topic of average income came up, and so I looked up the average (mean) salary of a graduate from an accredited 4 year school at the time, which was around $50,000. This statistic was compiled by the government and some educational agencies, composed of many thousand data points, and vetted by professional statisticians - but one girl in my group refused to believe it. "That's way too high!", she exclaimed indignantly. I asked her why she thought so, and she said "Well I know this one girl who graduated in social science..." Ok, so she knows one girl who graduated from a particularly low-paying major, and... that trumps a huge mountain of professionally culled data? She took statistics class too, so she should have known better. In fact I asked her "Ok, how many samples should you have to get a 95% confidence level if there are say, 100,000 college graduates in the US?" Again, the deer in the headlights look. I don't expect everyone to memorize every formula, but they should at least remember the concepts, so they should remember what to do and where to look up the formulas. She had no idea what I was talking about. I eventually calculated it for her, after showing her the formula in the statistics book we had used a few terms ago. As you can probably guess, the required sample was much larger than one person. Even without doing the math, she should recognize that "a girl she knows" is not valid data.
(In case you're wondering, I am not picking on females, the majority of the people in my finance program were female.)
Later, in my MBA program, after we discussed "sunk costs" in our accounting class, we had another class. We had to weigh options, and sure enough, one of the girls said "I would choose this option because it would be ashamed to waste all the effort and money already sunk into it." Doh! It seems like people can remember things to pass the test, but forget about actually understanding and applying them. I talked with her after class, and it turned out that she had never really understood the concept, even though she knew the right answer when it was directly asked. I explained it to her like this "Say you have put $5000 into fixing your car over the years, but it broke again last week. Fixing it would cost another $5000. Or, you can buy a new one for $4000." She looked at me and said "Why would I spend $5000 to fix a junker when I could get a new one for $4000 - ooooohhh I see...." Exactly.
If these kinds of problems were limited to the classroom, it would be mostly harmless, but unfortunately they are not.
One person at my old company came to me to ask advice on whether they should buy into the employee stock purchase plan. I told them that depended on whether they were comfortable with the risk. "Well I already own $5,000 worth", he said. I asked him when he had purchased the stock, and he said "oh, about 5 years ago." The vesting period was only two years, so he was eligible to sell the stock he had. I told him "Ok, here's what you should do. Even you don't want any more stock, but you are comfortable owning what you have: Sell $2,000 worth, and buy $2,000 more." By doing this, he would make a profit on the original stock he had purchased, and get a 20% discount on the new $2,000 worth - while keeping the same position. "I don't know... that seems complicated.", he told me. One couldn't ask for a better deal. (The only disadvantage to the deal would be that he would have to hold the new stock for 2 years from the date of purchase, and he wasn't planning to sell his stock anyway).
One of my friend's parents came to visit her while we were in college. They knew I was a finance major, so told me that they were planning to invest a lot of money into a single telecommunications company and asked me what I thought. I told them that putting a large sum of money into the stock of a single company was more akin to gambling than investing. They disagreed and told me it wasn't gambling because they were certain the company was solid - although they admitted that they hadn't done any research on the company, and were relying on a "tip" from a friend. About a year later my friend sheepishly told me that her parents had lost most of the money they put into that company - and the market was up from the point when they invested.
More to the point, everyone seems to think they know everything there is to know about investing, without having taken a single course in finance. Everyone always tells you how much they made on stocks, while nobody ever tells you how much they lost. One particularly noisy fellow was bragging to me at lunch one day, and so I called his bluff and said "Ok, if you want to brag, go home and print out all your stock purchase and sale history for the past 5 years and I'll check it out." Needless to say, such evidence never appeared. I don't think people are purposely lying either, they just happily remember gains while rationalizing losses away. Any way around it, though, nobody is going to make a living by day trading unless they are exceedingly lucky, or are trading on illegal information. Even if they were right 51% of the time (which over the long term would mean they were luckier or smarter than average), the brokerage fees and taxes would eat their returns up. This doesn't mean that the average investor is dumb, just that it's exceedingly hard to immagine them competing with the professional investors - and even they have a hard time turning a profit.
Many times, people have an attitude similar to the girl in my finance class, saying things like "Well I know Google is a good company..." - but they don't understand that such things may already be priced into the stock. Explaining the dividend discount model is a bit much for some people, so I explained it to one guy this way:
Me: "Ok, a Hershey bar is worth $1, right? and a Godiva bar is worth more, but how much is it worth?"
Guy: "Maybe $2?"
Me: "Right, because it's better somehow. But is it worth $20?"
Guy: "No way."
Me: "So we both agreed that it's better, but it's not worth $20 - why not?"
Guy: "Because, it's not *that* much better - it's not a good deal at $20. - ooooh"
Right, IBM or Google might be great companies, but they might or might not be worth their current stock prices. There is a difference between a good company and a good deal.
In general I find this theme repeating itself, people find it difficult to evaluate things like stock because they aren't so familiar with purchasing stock as they are DVD players or candy bars. Yet, at the same time, people who would spend their entire weekend doing research and checking out to different stores to get the best deal on a DVD player think nothing of spending thousands of dollars on stock that they don't understand.
Another person I know told me that they needed to save up some money, and they would need to spend it in two years - after which they asked me which stocks they should invest in. On the one hand, the market trends up, so if they had "extra" money they were willing to risk, they would be better off putting it in the market than not - but on the other hand, if the needed the money in two years, it makes little sense to put it in the stock market at all.
I'm not going to say they should have to learn all about finance or hire an expensive financial advisor, but at least they should know two things:
1. Investing in index funds is the safest thing to do in the stock world
2. If you need your money soon and/or aren't willing to risk losing some (or even all) of what you put in, don't buy stocks.
The magical value or property
In the mid 2000s, I knew a bunch of people who were really gung-ho about buying houses. Again, people came to me to ask what I thought. (It's been my experience that when people ask me what I think, they really want me to just validate their existing plans.) I explained that I wasn't an expert in property, but I would do a little research. The results were basically that property values in the US go up and down, but on average they tend to go up by an average of a little over 1% per year in the long term. (Also, they go up and down in different regions at different times, not always at the same time). I told them that buying could be better or worse than renting, depending on the property taxes, insurance, and mainly upon the interest and real estate agent fees. Mainly, I doused their enthusiasm by saying "You shouldn't expect your property to double in a year or something, it goes up 1% on average." Of course, looking at the actual data is a downer, so people preferred anecdotes that supported their proposed action: "Well my friend Bob just doubled his money in two years!" Well, ok, I'm not going to stop anyone. Then the bubble popped in 2008. So much for "Housing prices never go down." Seriously though, the same people who would comparison shop for their laptop can't be bothered to look at publicly available government statistics on housing prices.
Speaking of bubbles, it can be difficult to tell when you're in a bubble, and very difficult to tell when the bubble will pop - but sometimes it doesn't take a rocket scientist to figure out when a bubble is happening:
1. There is a rent-buy parity, which makes it possible to tell when housing prices are likely not "right".
2. When the price a house sells for is a lot more than it would cost to build a new house in the empty lot next door, something is very wrong.
3. When the P:E ratio stocks gets to be such that the companies would have to grow at 30% per year for the next 100 years in order to justify their prices, something is wrong.
etc.
Then there's the "How much house should I buy?" question. In America, the default answer seems to be "However much I can afford - and then some."
The logic apparently goes like this "If I buy a house for $100k today and sell it for $200k next year, I will make $100k! - but if I buy a house for $500k and sell it for $1M next year, I will make $500k!!" Fair enough,
- Assuming you are so lucky that the value of your house doubles in a year.
- Assuming that you wanted to buy it for investment, rather than living there.
- Assuming that you were willing to take the risk that it might drop in value, or stay the same.
- Assuming you didn't mind paying property taxes on a $1M house in the meantime.
- Assuming that you didn't mind paying such a large brokerage fee twice.
- Assuming that you didn't mind paying the interest on the more expensive house.
Interestingly enough, I happened to have a friend working in the real-estate industry in 2007, and she kept telling me how crazy everything was "People are taking floating rate loans on houses they can just barely afford - if the rates go up, they are going to be homeless. I can't believe the banks are giving them those loans in the first place." Sure enough, problems ensued.
The Magic Finance of Housing
Yet in planning to buy a property (or anything on a loan, really), you can think of it this way - banks make money on interest. The more you borrow, the more they make. In fact, if you borrow enough, they don't just make more dollars, they make more in terms of percentage as well (since your risk of default goes up, they can charge you more). Even if the percentage didn't go up, the length of the loan probably would.
Think about it this way, let's consider two scenarios:
- You borrow $250k to buy a house, and you have to pay 5% interest.
- You borrow $500k to buy a [bigger] house, at 5% interest.
If you can pay all the interest off before any of it is capitalized, you might "only" pay twice the interest for scenario #2 as scenario #1. (To keep things simple, let's assume you aren't paying property tax, insurance, brokerage fees, etc., and you are borrowing 100% of the home value, and the loan would be for 30 years).
Your monthly payment for #1 would be $1,342, and the total amount you would pay over the lifetime of the loan would be $483,139. The amount of interest paid would be $233,139.
For number two, the amounts would be monthly payment: $2,684, Total Amount: $966,278, and Interest: $466,278.
This is all assuming that you could actually get the second loan at the same 5% interest rate as the first one.
Note that in either case, the bank gets to make almost the value of your house! By the time you are done paying, nearly half of your money went to the bank instead of your house. Building equity, indeed.
Now here's the thing, if you could afford loan #2, then you could also afford to pay the $2,684 towards loan #1. Now you might think "Aha, if I pay twice as much, it will be done in only half the time, 15 years!" Wrong, since you will be done quicker, you'll also pay less interest - and since there is less interest to pay, you will be done even more quickly! In fact, if you took the cheaper house and paid $2,652 per month (You can spend the extra $32 per month at Starbuck's), you would be done in just 10 years. That's right, pay only twice as much and you will be done in one third of the time - but that's not even the interesting part. Your total cost has now gone down to $318,196. You save $148k by paying faster. Yet if you buy a house you can just barely afford the monthly payments for, then you won't have the option to pay double. I should also note that 15 year loans are usually about 1.5% cheaper in the US than 30 year loans, which means that in the scenario above, you would be able to get the loan for option number 1 for about 3.5%, and in that case... you could pay off the loan in about 9.5 years at the lower interest rate, and pay only $294k. In other words, you could pay $233k in interest to the bank, or $44.2k - the choice is yours. I don't know about you, but my personal goal in life isn't to make my bank rich.
I know, I know, some people will be saying "But I have to live in the stinky $250k house for 10 years" - perhaps, but once you pay it off, you can rent it out and use the rent from it to buy the $500k house you want - in another 10-15 years instead of 30. (Assuming you combine some of your own money with the rental income from the first house). I know, the choice is difficult: One $500k house in 30 years, or two houses totaling $750k value in 20-25 years. (While paying significantly less).
Of course the only problem with all of the above is that some people can barely afford to pay off even their cheapest option in 30 years.
Another option is to rent, and put the extra that you would have paid into the mortgage into some other investments. The trade-offs involved there are more complicated, and depend upon more factors, so I will dig deeper into that another time.
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