I recently read about a study in MIT Technology Review that looked into the relationship between intelligence and success.1Source: MIT Technology Review The researchers tried to learn the connection between being smart and being rich.
They concluded: “The most successful people are not the most talented, just the luckiest.”
I think this is true. There’s no correlation between knowledge and wealth. As Warren Buffett once said:
“If past history was all that is needed to play the game of money, the richest people would be librarians.”
The truth is that smart people have all the tools and ideas at their disposal to get rich. And yet, they often don’t use them. They tend to make the same mistakes over and over again.
Here are some of those mistakes. Can you relate to these? If you can stop making them, wealth is an inevitable outcome.
1. Over-optimizing financial decisions
In my own journey, I’ve noticed a tendency among highly intelligent individuals to fall into the trap of over-optimization.
They spend countless hours researching and analyzing to make what they believe is the “perfect” financial decision—whether it’s about investing in stocks, buying insurance, or choosing a mortgage plan.
The irony here is that while seeking the optimal choice, they often miss out on good opportunities that were right in front of them. The lesson? Keep it simple.
Money is a really straightforward concept.
- If you borrow money, you have to pay it back with interest, which means you pay back more than you borrowed.
- You probably won’t be able to always make money by working. We all get sick or injured. And most of us can’t work until old age. So think about your future earnings.
- Keep your spending under control. If you structurally spend less than you earn, you build wealth.
- It’s better to be an owner than a lender. If you get interest on your savings account, you’re lending your money. The upside is fixed. If you are an owner (of stocks, property, businesses), the upside is higher.
- If it doesn’t make dollars it doesn’t make sense. Forget about opportunities that you don’t understand.
If you keep that in mind, you’ll save yourself a lot of financial trouble in the future.
2. Following the herd
The herd mentality, also known as the “madness of crowds,” is a powerful psychological phenomenon. It’s when folks mimic the actions and decisions of others, often discarding their own analysis and beliefs.2Source: Investopedia
In investing, this can lead to speculative bubbles where you can lose a lot of money.
Following the herd isn’t only an investing phenomenon though. There’s a lot of herd behavior in society as well. Think of buying cars, clothes, accessories, or going on vacations. We tend to want what others want.
So try to step away from the herd. Pave your own path. Enjoy a simple life.
3. Focusing too much on the past
Hindsight bias is the tendency to convince oneself of accurately predicting an event before it happens. This can lead people to conclude that they can accurately predict other future events.3Source: Investopedia
Many investors selectively remember their successes while forgetting failures, distorting their perception of investment prowess.
“If it worked in the past, it will work again.”
Maybe. But it’s not a guarantee. The same is true in our careers. We can’t expect to always generate income with our existing skills. Just think of all the jobs that no longer exist.
Relying on hindsight bias can lead to excessive risk-taking based on perceived patterns that may not hold in the future.
4. Trying too hard
Regret aversion is the tendency to avoid decisions that may lead to regret, even if those decisions could be financially beneficial.4Source: NCBI
Investors often hold onto losing investments for too long or avoid buying undervalued assets for a couple of reasons:
- They’re too scared of making the wrong investment decision;
- In contrast, they may also fear not making big money by missing out on hyped stocks;
- Or they became unwilling to evaluate their positions properly.
This bias can lead to irrational behavior, such as trying too hard to make money. That can lead to taking excessive risks or becoming overly risk-averse.
To overcome regret aversion, stay centered. Balance is key.
5. Treating money differently based on its source
Mental accounting refers to the tendency to treat money differently based on its source or intended use.5Source: Investopedia
For example, some people may be more likely to splurge a tax refund on luxury items rather than saving or paying off debt. Simply because they see it as “extra” money.
The same thing with a holiday bonus. Most of us would rather spend it than invest it. Why? Money is money.
We really should treat all money equally. It doesn’t matter how hard or easy you were able to get it.
6. Focusing on losses
Loss aversion is the tendency to prefer avoiding losses over acquiring equivalent gains.
In investing, this can manifest as holding onto losing investments for too long in the hope of breaking even, rather than cutting losses and reallocating resources more effectively.
This bias stems from the psychological pain associated with financial losses. And because losses hurt more emotionally than achieving gains, we tend to focus more on the losses. As the stock-picking legend, Peter Lynch, said:
“People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game.”
This was my biggest mistake when I started investing. I had a negative experience the first time I bought stocks, so I became too focused on the potential of loss.
In fact, this is a common mistake about stocks and Wall Street. So many people think that it’s for rich people and that the suits are scamming the regular folks. Sure, there might be truth in that.
But you can’t deny that the stock market is the greatest wealth builder on the planet. Try to focus on that instead.
7. Confirmation bias
Confirmation bias is the tendency to seek out, interpret, and remember information that confirms one’s pre-existing beliefs while ignoring or discounting information that contradicts them.
This bias can significantly impact financial decision-making by leading individuals to make choices based on incomplete or skewed information.
Sometimes you get an idea to invest in something and you start looking for evidence to back up your idea. It’s easy to cherry-pick positive arguments for any investment. But when it comes to your money, you must also play the devil’s advocate.
Be skeptical of your own ideas. And this is probably one of the hardest things. We tend to be overly optimistic when we think we have a good idea.
But we can’t let that optimism get in the way of making sound financial decisions.
By understanding and addressing these psychological biases, everyone can improve their financial decision-making. That’s how you achieve long-term wealth and success.
