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How dumb investment decisions may be doing you in

Reprinted courtesy of MarketWatch.com.

To read the original article click here

This column was inspired by a recent episode of “This American Life” on the topic of bad choices made by good people who should (and probably do) know better.

Malcolm Gladwell tells the story of how Wilt Chamberlain, one of the 20th century’s all-time best professional basketball players, found that he could double the success rate of his free-throw shots by shooting underhanded.

In the free-throw-shooting episode, released this week, Gladwell explores Wilt Chamberlain’s flirtation with the underhanded style. The method, also called “granny style” shooting, was favored by Rick Barry, a career 89.3% free throw shooter, and it helped Chamberlain shoot a career-best 61% from the line in 1961–62, the same season he sank 28 of 32 free throws in his record-setting 100-point game.

Much to Gladwell’s dismay, however, Chamberlain reverted to traditional foul shooting, his percentages predictably plunged again, and he later admitted that he felt “like a sissy” when he shot underhanded.

As a result, his teams undoubtedly lost games they would have otherwise won. Wilt should have known better, and his choice was costly.

He and his teammates probably made less money than they would have otherwise. He set an example to other players that might be paraphrased as something like “Looking cool is sometimes more important than scoring points.”

Gladwell’s underlying point is clearly stated: Why would a Hall of Famer reject a proven, simple solution to his most obvious flaw when another Hall of Famer used the exact solution to historically great effect? And in turn, why have modern players largely followed in Chamberlain’s footsteps rather than Barry’s?

The Chamberlain/Barry dichotomy leads naturally into an exploration of high-threshold vs. low-threshold personalities. In the simplest sense, a high-threshold personality (like Chamberlain) is more likely to allow a crowd to dictate his behavior, while a low-threshold personality (like Barry) pursues the preferred course with less regard to social cost. By the end of the episode, Gladwell finds himself “admiring” the polarizing Barry’s willingness to shun hecklers and groupthink as he perfected the method of foul shooting that ultimately maximized his ability and value.

What bad choices cost us

Wilt knew the facts and chose to ignore them. Why do people knowingly make dumb choices? I’m no psychologist, but I think there are plenty of reasons. Chief among them may be that we let our emotions (for example an aversion to being called a sissy) overrule the facts.

Unfortunately, millions of investors who should know better still do things that are counterproductive. A major case in point: Paying unnecessary expenses.

One simple fact is inescapable: Every unnecessary dollar that you pay in investment expenses is a dollar that could have been yours to spend, but which instead will be spent by someone else.

Most savvy investors, certainly including the people who are likely to be reading this column, already know that the probability of long-term success is higher with index funds than with actively managed funds.

Low-cost index funds are likely to leave you more money in retirement, more money to leave to your heirs, more money after the tax man gets through with you and more peace of mind along the way. They are also likely to teach (by example) a better lesson to your kids (at least if they are paying attention).

When emotion takes over

Speaking of letting emotions overrule other factors, I remember meeting with a couple some years back whose son had taken a job working for a brokerage firm. They wanted to help him in his budding career and gave him their business, even knowing this was boosting their expenses (not to mention also reducing their son’s potential future inheritance).

For them, the relationship was more important than getting the highest return for their money. I’m a parent, too, and this couple knew what they were doing; I can’t categorize this choice as a dumb decision. (I don’t feel quire so magnanimous, Wilt Chamberlain.) Still, from a purely financial standpoint, this was highly likely to be counterproductive.

Brokerage firms count on the emotional pull of friends and family when they hire young brokers.

I have a friend who was trying to get a job with one of the country’s largest brokerage firms. Before he was hired, he was required to make a list of at least 250 friends and family members he thought he could solicit for new business. When you give your business to your brother-in-law, you could be playing right into the hands of Wall Street.

The big boys

I am always a bit suspicious when I hear investors complaining about the one-percent, the highest earners. People say they are sick and tired of seeing these one-percenters get all the benefits while the rest of us work hard to meet our needs.

I don’t like this disproportionate wealth any more than the next guy. But when you give your business to a large brokerage firm, you are helping a lot of one-percenters stay propped up on their lofty perches.

Instead, you could deprive those wealthy institutions of some of their riches (and do yourself a favor) by putting your investments into low-cost index funds or ETFs.

Doing that might help you avoid another pitfall: illegal (and sometimes fraudulent) behavior by big brokerage houses.

Merrill Lynch, owned by Bank of America and the home of many one-percenters, recently agreed to pay more than $400 million to settle charges of wrongdoing by the Securities and Exchange Commission. The firm was accused of misusing cash that belonged to customers and failing to safeguard their securities.

According to the SEC, Merrill Lynch exposed its customers to a potential “massive shortfall” if the company had failed to make profitable trades, which were financed with customers’ funds. This illicit financing amounted to billions of dollars every week from 2009 to 2012. The firm also held as much as $58 billion in customers’ securities in a clearing account that was potentially exposed to liens by its clearing bank.

Nobody lives a perfectly rational life, including yours truly. We can all learn to do better.

I recommend you use the link at the beginning of this article to listen to this recent episode of “This American Life.” If you find it even half as interesting and enlightening as I did, you may be able to find ways to stop acting in a counterproductive manner.

Richard Buck contributed to this article.