How do you pronounce the capital of Kentucky: "Loo-ee-ville" or "Loo-iss-ville"? Now, how much money would you bet that you know the correct answer: $5, $50, or $500?
This question, from the behavioral-economics book Why Smart People Make Big Money Mistakes (1999) by Gary Belsky and Thomas Gilovich, is really a trick: Kentucky's capital isn't Louisville; it's Frankfort. While you were congratulating yourself for knowing the s in Louisville is silent, you probably didn't stop to wonder if that was all you needed to answer the question — a display of the human tendency toward overconfidence.
Excess confidence leads people to think too highly of their own skills — even in areas in which they aren't very skilled. Eric Dahm, an investment adviser at Human Investing in Portland, Oregon, sees this in clients who hold a lot of retirement savings in their employer's stock. "When we point out the danger of having a large portion of assets tied up in one stock, they'll often respond, 'I work here, I see what they're doing, and I think this stock is going up forever,'" Dahm says. "I watched one client do that — and he rode the stock from $60 a share all the way down to $3."
One way to combat overconfidence is by avoiding the temptation to use your stock-picking skills to invest in individual companies. Instead, select a handful of highly rated mutual funds — no more than half a dozen — that invest in diverse companies in different parts of the world.
You're picking out a movie to watch tonight. Lowbrow comedy or highbrow art film? Now imagine you're picking a movie to see in two weeks. Which type will you want then?
In a 1999 study published in the Journal of Behavioral Decision Making, researchers found that 56 percent chose the popcorn flick for tonight and 44 percent went for the more intellectual option. But wait: Move the date forward by a couple of weeks and 71 percent picked the art film. Blame "hyperbolic discounting," which is a wonky way of saying that we prefer immediate rewards and postpone things we think will be good for us.
This sort of choice pits two different decision-making processes in the brain against each other. One side — Thaler calls it Mr. Spock — is extremely rational and deliberate; the other — Homer Simpson — is impulsive and emotional. And when the two of them fight, Homer tends to win: It can be hard for your Spock side to save for retirement when your inner Homer is drooling over big-screen TVs and other expensive distractions. The solution? Eliminate Homer by automating your savings. Your 401(k) plan does this brilliantly, spiriting your money away before you see it. Do the same with your IRA or emergency fund by setting up automatic transfers from your bank account. "Automatic savings plans are incredibly powerful, because they keep the part of your brain that's interested only in immediate rewards from participating in the decision," says Russell James, an associate professor in the department of personal financial planning at Texas Tech University. "That's a great way to get yourself to set aside more money for your retirement."
Michaela Cavallaro writes about personal finance and works on her self-control issues in South Portland, Maine.
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