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Why Smart People Do Stupid Things with Money

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investing book reviews financial planning behavioral finance

Why Smart People Do Stupid Things with Money

Overcoming Financial Dysfunction

In today’s off the beaten path book review, I’m taking a look at Why Smart People Do Stupid Things with Money by Bert Whitehead, MBA, JD. This review is based on the 3rd edition published in 2007 and not the current 4th edition. As part of my series of off the beaten path book reviews, I’ve scoured the internet for books that might not be found at the local bookshop where we might find a new nugget of information or some fresh new way of seeing things.

At first, I thought Why Smart People Do Stupid Things with Money was going to focus more on current behavioral finance ideas such as in Dollars and Sense by Dan Ariely and Jeff Kreisler. As Dollars and Sense goes:

The truth is, making bad money decisions is a hallmark of humanity. We’re fantastic at messing up our financial lives. Congratulations, humans. We’re the best.

However, Why Smart People Do Stupid Things with Money presents mostly from the perspective of first generation behavioral finance rather than how we think of behavioral finance today. It is no surprise given that behavioral finance really emerged as a field of interest in the 1980s just as Mr. Whitehead was beginning to build his own practice. The value of the book comes from Mr. Whitehead’s experience helping real people, who turn out not to be rational economic agents.

But behavioral finance has evolved from looking at behavior as irrational and something that has to be fixed or treated to a more accepting view that it’s just being human. For instance, Mr. Whitehead defines financial dysfunctions as ways that would cause someone to lose their financial freedom. Financial dysfunctions are related to a poor medical condition, just like not taking care of yourself through diet and exercise can lead to being unhealthy and overweight.

Current behavioral finance takes a view where dysfunction equates to being normal and works within that framework to better understand decision making. That means we begin to focus on wants as being “ok” versus a source of cognitive errors that need to be fixed. For instance, let’s look at one of Mr. Whitehead listed financial dsyfunctions, mortgage aversion. Mr. Whitehead makes a reasonable and rational argument on why carrying a mortgage without paying it down makes financial sense when compared to investing that money at potentially higher rates. However, if we rearranged the chapter sequence of Why Smart People Do Stupid Things with Money and started the book on Chapter 6, where we focus on goals and values, then the perspective changes and the view shifts from a financial dysfunction to expressing a want.

To be clear, the goals we are talking about are more than just owning a second home or saving for college or retirement. We are talking about identifying goals and values such as: achievement, adventure, aesthetics, autonomy, health, integrity, intimacy/friendship/love, recognition, service, spiritual growth, wisdom. If we start the process here, with these kinds of questions, focusing on values, then I believe you get a more positive framework to start the planning and educational processes contained in Mr. Whitehead’s book.

And this is where Mr. Whitehead offers a unique way of combining education and planning utilizing his financial life cycle approach. This is a valuable nugget. His approach views that we must work through the steps of the financial life cycle regardless of where we are currently chronologically. This ensures that the financial foundation is sturdy to achieve financial fitness. I’m sure it’s the case that in reviewing situations, many must regress to an earlier part of the financial life cycle to pick up the needed habits to gain financial fitness. This approach provides structure that quickly helps identify where planning and education needs to start given ones current financial situation.

After a review of the financial life cycle, the book shifts to investing and portfolio construction. Not surprising, the book eschews modern portfolio theory for something called functional asset allocation. Mr. Whitehead explains the process from the perspective of a farmer and their farm. In the farmer metaphor, the pantry contains the fixed income portion of the portfolio, the garden represents the real estate portion including a personal residence, and the crops represent equities. Ultimately the asset allocation if presented as a pyramid with each building block serving a purpose.

It doesn’t take much to extrapolate the pyramid approach to a behavioral portfolio built as a pyramid of mental accounts. These mental accounts are based on wants, which have associated goals and values. This would be more congruent with a focus starting with Chapter 6. This way in the planning and education process you can have a better insight into whether someone is making a cognitive error or just expressing their wants.

There are valuable nuggets to be taken from Why Smart People Do Stupid Things with Money. However, I would approach it differently, avoiding much of the initial discussion on financial dysfunction. My personal approach to enhance the value of the book would be to start with goals and values (Chapter 6) and identifying financial personalities (Chapter 3). Based on that initial work one can begin to discern between expressions of wants and cognitive errors. I would then move to the planning and education phase as described by the financial life index (Chapter 7) and functional asset allocation (Chapter 8). As part of the asset allocation discussion I would incorporate the risk section in Chapter 5. The pyramid approach to asset allocation using mental account would further the discussion of wants versus cognitive errors based on mental accounting.

In a crowded field of financial planning books, I believe Why Smart People Do Stupid Things with Money has value especially if modified to reflect a more current view of how behavioral finance can be used in the planning process.