When it comes to financial decisions — as well as non-financial ones — most of us think irrationally much of the time. The fascinating field of behavioral economics sheds much light on this. For example, in an experiment, when members of a wine club were told a bottle of wine cost $45, they preferred it over a $5 bottle, even though both actually held the same wine. We tend to attribute more value to things that cost more — and this can be costly to us.
In another scenario, imagine two stores trying to unload an item that has been priced at $5. One store advertises it at 60 percent off and the other announces that it has been discounted by $3. Both stores are selling it for $2 now, but consumers are more likely to be drawn to the 60 percent sale, as it seems like a deeper discount.
Meanwhile, most of us think we’re above-average drivers, due to our tendency to be optimistic. This can be costly in investing, if we give short shrift to the possibility that a stock is overvalued or may fall. The “bandwagon effect” suggests that we often do or think things solely because many other people do so, too. Unfortunately, by sticking with the herd — especially in the stock market — we often set ourselves up to fail. As Warren Buffett has advised, a path to profit is to be greedy when others are fearful and fearful when others are greedy. Stock market crashes are good times to buy, not sell, even though others are selling.
The strategy of value investing, which Buffett has practiced, is based on not following the crowd. Value investors seek companies that are trading for considerably less than they’re worth. They owe their bargain prices to a general lack of respect from the market. They tend to be overlooked, forgotten, unloved and underestimated — but to still have solid growth potential.
Learn more in “Why Smart People Make Big Money Mistakes” by Gary Belsky and Thomas Gilovich (Simon & Schuster, $16) and “Predictably Irrational” by Dan Ariely (Harper Perennial,
$16).
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