This week, I’ve decided to do a little series of “afternoon brain snacks” from the seven chapters of Why Smart People Make Big Money Mistakes and How to Correct Them: The Science of Behavioral Economics by Gary Belsky and Thomas Gilovich. Sort of a summary/commentary. Today’s chapter is titled “When Six of One Isn’t Half a Dozen.”
Today we’re talking about loss aversion and its consequences. Long chapter, but I’ll do my best to summarize.
On loss aversion — they show several studies to argue that people feel more pain about loss than they feel pleasure about gain. This can be good, as it keeps us from taking stupid risks. But it can also lead to behaviors which make little financial sense. Because we try to sate the pain by making more bad decisions so we don’t yet have to admit the first ones were bad.
For example, the “sunk cost fallacy” — throwing good money after bad. If you’re sewing a quilt top and decide you don’t like it, do you continue? Do you still buy the batting and backing and put it together?
Either way, the original money is lost. Unless you hope to recoup more money than you spent (and include your time in this valuation) by selling the finished quilt, then there’s little point in going on. You can’t get those $50 back, but you can save yourself from spending $50 more and spending more hours on it.
But if you’re like me, you feel that you owe something to this project because you spent the money in the first place. If you have tickets to the big game but feel really sick then don’t go…you already spent the money so you can’t get that back (unless you can think of some quick and clever way) and going would make you miserable. It’s not worth it.
Buying more of a bad stock is another example. You’re trying to convince yourself that it’ll go up this time. You don’t want to feel like an idiot for investing in something bad. Paying for another year of tennis lessons when you found the first year miserable, because you don’t want to admit that it was kind of a waste. (Note: little is actually a waste. You found out you didn’t like tennis, right? You also got some exercise. And you know the basics now. Or maybe you’ve learned important things about buying stock/choosing quilt patterns/etc.)