Knowing Yourself Better Than Financial Literacy?
A friend of mine sent me a link to an article on “Why Being Financially Literate Isn’t Enough.”
It focuses on a side of financial literacy that is often lacking, the psychological aspect of knowing oneself.
I remember reading that one of the tenets of investment is the ‘sleep test’. This states that one should not invest if you cannot sleep when your stock portfolio shows a loss of 30%, 40% or for me 60% during the 2007-2008 period.
In the article it talks about our focus on just one specific part of our financial lives and missing out on the bigger picture. For example, depending too much on the stock analyst or friends around you for ‘tips’ on investing.
In Nassim Taleb’s book “Fooled by Randomness,” he exposes the random survival bias that we attribute to a person’s or company’s success. More importantly, in his book, he introduces us to the researchers Amos Tversky and Daniel Kahneman who showed that people are not rational when it comes to decisions involving risks. You can read about their experimental demonstration to Framing.
What it means is that if given a choice of two financial products which may lose $600 in a coming recession that you:
- will make $200. Scenario A.
- has 1/3 chance that you will make $600, but a 2/3 chance of making nothing. Scenario B.
More people will choose Scenario A (72%).
For another group with the same scenario, the choice is :
- $400 will be lost. Scenario C
- there is a 1/3 probability that no loss will happen and a 2/3 probability that $600 will be lost. Scenario D.
For this choice, they found that more people will choose Scenario D (78%).
People choose Scenario A because it is a sure win. However, when it is presented in a negative way in terms of a loss, people will opt for chance that there is no loss. Even if there is a high chance the eventual loss will be higher.
That is why we take profits quickly instead of letting them run. While we keep those stocks that are in the red, hoping for the chance that it will turn around.
Understanding this gives us an added advantage when it comes to scenarios where a better understanding of how your mind works lets you wait a while longer for profits to run and a decision to cut losses before it really hurts.
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