Test Your Money Instincts

We're not idiots. We know we're supposed to manage our money better. So why don't we?

See also: Fed up with fees. >>

The biggest reason may be our money instincts: They aren't particularly good. The fact is, people tend to choose immediate gratification over larger long-term payoffs ( like, say, a comfortable retirement), and we rationalize our behavior by telling ourselves we'll do better tomorrow. In a recent University of Michigan study of the Chilean retirement system, which has relied on 401(k) – like plans since the early 1980s, researchers found that investors' impatience is a major impediment to saving. "We all have self-control issues," says economist Richard Thaler, who directs the Center for Decision Research at the University of Chicago. "Our thought process often goes something like, 'I'd like to save more, but I'd like that big new TV even more.' Then we realize that football season is starting next week, and the idea of saving goes right out the window."

You may think you're more rational than that — and maybe you are. Let's find out. The following three questions are typical of the ones used by behavioral economists to demonstrate how and why we make financial decisions that go against our own interests.

Question #1

A salesperson is touting new windows to a homeowner. Which pitch is more likely to get a sale?

"Replacing the windows will save you money."

"You're losing money by not replacing the windows."

The two pitches mean the same thing, but the second is more effective. Why? People fear immediate losses more than they desire future gains. Behavioral economists call this "loss aversion"; they've documented we feel the pain of losing about twice as strongly as we feel the pleasure of winning.

The instinct to flee from losses probably served us well back when saber-toothed tigers presented a more pressing threat than plummeting stocks. Today, however, loss aversion can be less helpful. "The same instincts that prompt you to flee a burning building make you want to sell when the market's low and buy when the market's high," says Elle Kaplan, founder of Lexion Capital Management, a New York City wealth-management firm. "But that's the opposite of what you need to do to build and preserve wealth."

To counter the effects of loss aversion, avoid checking the balance on your investment accounts more than a few times a year, which should help you avoid the temptation to move your money in and out as the market gyrates. And if you can't trust yourself to keep your instincts in check, consider working with a financial adviser.

Next: The danger of overconfidence. >>