Ten Money Mistakes We All Make

Learn from the every-day mistakes our fragile brains make when we go hunting for bargains, pick shares, handle debts, or make any other financial decisions.

We all make a lot of mist cakes. I mean mistakes. On a weekly basis we perform dozens of logical errors, attentional errors and memory, um, things...Yeah.

The errors that our fragile minds make affect all aspects of our lives, including money decisions. Here are just ten of them to watch out for.

Error one

A primitive form of psychological pricing is to mark prices down from nice round figures like £10 to £9.99, but I don't expect many Fools are fooled.

More advanced techniques are discounts and three-for-two offers. Each of these make people buy things they otherwise wouldn't, purely because they think they're getting a good deal. Here's an example: if a shirt was priced at £40, you might um and ah over the cost of it. However, if it was £70 reduced to £40, you'd be more inclined to stretch your budget to buy it. Even though it's the same shirt!

Error two

There's an error we make (called, if you're interested, the availability heuristic) that causes us to make terrible decisions. Let's say you read over and over in the papers about one frightening terrorist attack on a plane. This makes you think how dangerous flying is, so you decide not to fly for the rest of the year. However, the odds of this event happening to you are ludicrously small. You're more likely to be struck by a car when crossing the street or to get cancer from sunbathing, but you don't stop doing those things, do you?

Of course, making fewer flights will probably improve your finances, but most of the time this type of error is more likely to cost you money. This happens, for example, when you hear or read about one bad experience someone has with a company, and from that you leap to the conclusion that it is more untrustworthy than its competitors, or that all its products are rubbish. Conversely, you may read about one good experience and presume that the company is all nice and fluffy.

I read posts from people making this particular error time and again on The Motley Fool's discussion boards. People refuse to use a company based on just one event. It's why, despite the occasional appeal from readers, I single out one financial company as 'bad' only with caution, because to do so could easily be misleading; they're all, pretty much, as foul and incompetent as each other.

Error three

Closely related to error two is when people over-react. I dunno what this error is called, but I call it over-reacting or, maybe, the 'It's all about the principle' effect. After having one bad experience with a company, sometimes people refuse to deal with them again based on an emotional reaction, which they justify in their heads as 'the principle'.

However, it's usually just the mistake of one employee, whom you'll never have contact with again. Or, you found out the company ripped you off with poor terms and conditions, so you refuse to take out a different, market-leading product from them, even though you know the conditions are better. This is to the detriment of your finances.

Error four

"What are the odds to getting sick on a Saturday?  A thousand to one!"
Homer Simpson

The gambler's fallacy is appropriate to both gambling (which The Fool strongly urges you is damaging to your wealth) and investing (which is sensible). This error is that you risk your money in a belief of a 'run of luck' or a mistaken understanding of the law of averages.

What happens is people have a run of luck, so they think that surely their luck must continue. Or they've had 'bad luck', so they think that surely it must turn around now.

What they don't grasp is that what has happened in the past has absolutely no bearing on what will happen in the future. If you've already tossed four heads in a row, for example, there is still a 50/50 chance that your next coin toss will be heads. (Whereas if all five coin tosses are still in the future -- meaning you are yet to toss the coin at all -- the odds of all five being heads is 1/32.)

These sorts of errors can be compounded by the opposite of the availability heuristic: denial!

Error five

The Lake Wobegon effect, and also the over-confidence effect, is about over-estimating your abilities, such as your prowess at stock-picking or other investment decisions. This is compounded when investors fall for the gambling fallacy, or have rosy retrospection (think 'rose-tinted spectacles'), or they simply don't analyse their past performance versus the stock market to establish whether they really have out-performed and are as good as they think they are.

The important thing to remember if you're trying to beat the market is that, collectively, investors and funds are the market, and the market can't beat itself. Furthermore, in order to beat the market, you have to outperform significantly, because of the costs of dealing with shares, or paying for fund managers' services. Are you really that good? The answer for most of you is 'No'.

Error six

I can't think what this error is called, but it's one that is made repeatedly: we give all our money to people we've never met before to invest it for us. What's more, we assume they're good at it. You might call this error simply stupid, but many an intelligent person does this: I'm talking about putting your money into funds that are managed by other people whom you know nothing about.

I'm still a young man, but I've been surrounded by investors, and I've read lots of articles, letters, reports and discussion-board posts from investors, and I communicate with workers in 'the City'. By soaking up all these experiences in a relatively short period (one of the perks of working as a writer for The Fool), I have found that the vast majority of fund managers and, indeed, private investors, are just average. These people are no smarter than you or I, and they don't beat the market.

Just to force this point home, an asset manager at a leading investment bank told me recently that all the equity-fund managers there were just average people, and that he would rather invest his money in a (very Foolish!) index tracker than trust his money with them...and he sits right next to these guys!

Error seven

The inverse of the Lake Wobegon effect is the worse-than-average effect. These traits appear when people perceive that their chances of success are extremely low, because they feel, incorrectly, that they are not capable of achieving what they need to. It might explain why people don't face up to their debts, when really there is always a solution, as our friendly and helpful Dealing with Debt board users will tell you.

Error eight

It's common for people to make an emotional purchase and then to try to rationalise and justify it afterwards. This is called post-purchase rationalisation. Don't try telling me you haven't done this before!

Error nine

Research has found that people disproportionately stick with any default choices when making decisions, for example, in retirement planning. Say that a group of people are offered three choices of investment fund for their pensions: low risk, medium risk and high risk. Let's say that half of these retirement savers are told that, if they don't specify a fund, the default fund will be the medium risk one, and the other half are told the default is the high-risk fund.

You might find that, of the first lot, 80% stick with the medium-risk fund, but of the second lot, only 40% switch to the medium-risk fund. This might be caused by the status quo bias, where people perceive a greater risk if they make changes.

Of course, you could also call this laziness.

Error ten

Investors make so many different sorts of errors, but I'll end with just two more. The first is confirmation bias, which is when an investor interprets information in a way that confirms his or her preconceptions. This could also be the cause of illusory correlation, which is when you convince yourself that there is a pattern in data when it doesn't really exist.

Hopefully, this catalogue of errors will make you take a step back before you make any financial decisions. Ask yourself: is your brain being fragile?

> Read more: Three Common Money Mistakes.
> Don't be lazy (or commit an omission bias)! You can get a better deal on your various financial products by clicking on the links at the top of this page.