Why We Keep Making Bad Financial Decisions

In the last issue, "Why Do You Make Bad Financial Decisions?" we saw that mistakes in perception lead to bad financial decisions. We continue to look at other reasons why.

German psychologist Ernst Weber said that our ability to detect changes visually depends on the starting point. He called the tiniest change possible before it is detectable JND for "just-noticeable difference." He discovered that in addition to vision, it also applies to all other senses and that JND depends on the starting point, which later became known as "Weber's Law." For example, you would be happy if a million dollars landed in your lap. But if it happened to Elon Musk, he would be happy too, just not as much as you. In other words, money has diminishing returns. Graphically, the perception of money is not a straight line: twice as much money doesn't make you twice as happy. More importantly, it works also in reverse: if you have $200,000 and lose $10,000, you won't have the same regret as when you had $10,000 and lost it all.

The Range Effect

You are shopping for a tablet that costs $200 and discover that you can drive 30 minutes across town and buy it on sale for $100. Do you make the trip? Imagine instead that you were shopping for a flat-screen TV for $2,000. Would you drive 30 minutes across town to buy it for $1,900? You probably will make the trip for the tablet because it is 50% off, but not for the TV because it is only 5% off.

That is a financial blunder because of the range effect.

Daniel Kahneman and Amos Tversky are researchers in Behavioral Finance -- Mr. Kahneman won the Nobel Prize in 2002. They found that most people will make that same decision. Like most people, you fell into the same trap. As in the last issue, where you thought the problem was about miles per gallon when it was really gallons per mile. You think it was about percentages when it was really about dollars. You are not trying to save percentages -- you are trying to save dollars.

Essentially, you were valuing $100 differently. The real question is whether 30 minutes of your time is worth $100. If so, you should make the trip for both the table and the TV. After all, 100 bucks is 100 bucks. Sadly, that is not the way people see money.

Tune in for the next issue when we look at more errors in how we think about money.