Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes with Your Money

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9780137147786: Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes with Your Money

"Adler’s argument is illuminating and reveals that, when it comes to investing, we should always have second thoughts about our first impressions."

--Publisher's Weekly


WHY YOUR INSTINCTS CAN BE YOUR #1 ENEMY—AND HOW TO DEFEAT THEM!

 

“David Adler’s Snap Judgment is a well-written, entertaining review of human action in risky situations, including stock market behavior and other risk-facing situations. In particular, Adler recounts the conclusions of many practitioners and behavioral finance scholars who have studied such matters. This book is well worth reading, both for its practical advice for the novice and its wealth of illustrations for the pro.”

— Harry Markowitz, Nobel Laureate in Economics and father of modern portfolio theory

 

“David Adler has done a great public service by translating a dazzling array of research in economics and finance into practical terms that anyone can understand and profit from. This book should be required reading for every investor.”

— Andrew W. Lo, Professor of Finance, MIT Sloan School of Management

 

“Investing and managing your money on the basis of emotion, instincts, and intuition is a road straight to the poorhouse. This book teaches you why—and how to rid yourself of the irrational impulses that torment your portfolio.”

— Peter Navarro, bestselling author of If It’s Raining in Brazil, Buy Starbucks and The Coming China Wars

 

“Adler’s book makes a compelling case, illustrated through engaging examples, that the mind and the purse are well served by the triumph of analytic intelligence over intuition.”

— Gary Loveman, Chairman, President, & CEO, Harrah’s Entertainment, Inc.

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About the Author:

DAVID E. ADLER is the producer of the forthcoming PBS NOVA documentary on behavioral finance and is a contributing high-net-worth writer for Financial Planning magazine, the leading industry magazine for financial planners. He is coeditor of the anthology Understanding American Economic Decline (Cambridge University Press). Adler has written for Barron’s, Institutional Investor, Psychology Today, and The New Republic. He was recently awarded a grant by the CFA Institute Research Foundation to conduct a study of tax awareness in investment decision-making by wealth managers. Educated at Oxford University and Columbia University, he holds an M.A. in economics from Columbia.

Excerpt. Reprinted by permission. All rights reserved.:

Introduction: Second Thoughts About First Impressions

Introduction: Second Thoughts About First Impressions

I can resist everything except temptation.
Oscar Wilde

This book is about the psychology of financial decisions. It is about how our instincts and intuitive judgments intersect with financial markets, as well as other areas of contemporary life, to produce decisions that are not in our best interests. It argues that our “intuition,” the psychological responses celebrated in books like Blink, may be a useful guide when falling in love, but when it comes to investing, fully trusting your gut is pretty much a disaster. It will only lead you astray when choosing a stock or predicting the end of a real-estate boom. Snap judgments and first impressions are poorly suited for calculating odds and probabilities, compounding interest, or forecasting the future behavior of the stock market.

This book examines decision making in many areas of finance, such as picking stocks, bonds, mutual funds, and health insurance, too. It looks at how gamblers misperceive odds, and ways both sports teams and corporations could improve their strategies through a better understanding of probabilities. It shows how we naturally extrapolate current financial trends into the future, causing us to become irrationally optimistic—or alternatively to panic and subject ourselves to doom-and-gloom scenarios. The finance industry is well aware of our intuitive errors when it comes to investing and knows exactly how to get us to make the wrong move.

The message of the book is a positive one, and also a pragmatic one. When it comes to investing, you can teach yourself to recognize your instinct-driven errors. This will allow you to temper your intuition, where appropriate, with more deliberate and also more informed thought. Through conscious effort we can resist the siren call of our gut instincts.

This book also comprehensively presents the most interesting recent findings of the rapidly growing field of behavioral economics, which draws on both psychology and finance. Some of the early ideas of behavioral finance are now widely known and are part of the mainstream of investment advice. But there is much more contemporary research that has not yet filtered out to a wider audience, and remains only in the hands of specialists. Whenever possible, I interviewed the creators of these newer ideas, to get it straight from the horse’s mouth, or economist’s mouth so to speak. Investors can profit from this new research, and I mean that literally. Keynes once compared the stock market to a beauty contest, where the goal was not to pick the contestant you found the most beautiful but instead to be able to spot the one everyone else was going to select. If you know how other investors judge stocks, think about markets, and are going to behave, that gives you an enormous leg up. This book discusses several persistent “anomalies,” predictable departures from market efficiency, where through an understanding of investor psychology, rational investors can improve their chances of beating the market.

There is also a more ominous theme to the book. Relying only on intuition in finance—making the decision that seems right and feels right—can lead to very bad outcomes, not only for individuals but also for markets. These gut instincts, uncontrolled by self-regulation or government regulation, can give rise to huge financial bubbles. As we all know now, the U.S. spent the last decade or so in the grip of a mass euphoria of twin real-estate and credit bubbles. Individual investors and investment bankers made errors in judgment. The system, and the people in it, seemed to be in a sort of dream state during the bubble years. This was more than simple greed. Rational thought was in short supply. Few people worried about the possible fragility of the system itself. Rising markets made investors complacent, stifling good judgment and decision making. Using gut instincts and intuitive perceptions for guidance, aided by dubious mathematical models that few explicitly questioned, no one saw the true dangers ahead, leading to a financial catastrophe.

Gut Instincts and Evolution

Cognitive psychologists and decision theorists believe we have two decision systems at our disposal. The most immediate, written about in Malcolm Gladwell’s Blink, is very quick, based on first impressions. These are snap judgments that occur almost instantaneously in the blink of an eye, with little deliberation. The ability to make quick intuitive decisions is an evolutionary adaptation, according to evolutionary psychologists. It developed so humans could function in early environments. Speed in thinking was everything. When should you run from a mammoth? Or toward a mammoth, hoping to spear it for dinner? Pausing to deliberate in such a moment could literally kill you. The brain of early man needed to fire off answers to these questions in a split second.

More generally, evolutionary psychologists argue that our early brains evolved to make quick decisions for another reason: Early man needed to master his rapidly changing social environment. This was central to human development. Our cognitive capabilities are hard-wired to interpret and understand social cues. These social mechanisms are still present in our brains and pervasively color all of our thinking, including our assessment and interpretation of abstract patterns with no human presence.

Today, there are certain areas of life where this quick thinking, human-oriented decision system—call it intuition—still works well. Understanding the contemporary social environment is one of them: Is the colleague from the cube next door, that you are having lunch with, a friend? Enemy? Frenemy? Snap judgments rather than conscious deliberation may be your best guide.

Interpreting language cues, even when extremely subtle, is another area where you don’t have to think too consciously to understand what is going on. People make inferences based on language and do so astonishingly fast. Take, for instance, the seeming compliment in the phrase, “Well, I liked your book,” overheard in a conversation between writers. As opposed to reading it on the written page, listening to the delivery reveals this is not necessarily a compliment at all but instead could be meant as an insult. Emphasis on the word I conveys a hidden meaning, “Yes, maybe I did like it, but this was in contrast to everyone else. Everyone else hated it.” An analytical or nonintuitive approach would miss the hidden dig. Similarly, artists undermine each other with the description, “She’s a competent painter.” The listener can infer this means nothing good, that the artist in question is mediocre and unimaginative.

Our intuition is also pretty good at recognizing how frequently things occur in nature. (Animals, in general, are good frequency detectors. They seem to uncannily forage in exactly the right place. They vary their foraging grounds in an evolutionarily determined, precise way so as to maximize caloric intake while minimizing caloric expenditure.) Our intuition can perform many other extraordinary feats: We are great at face recognition—we can pick out a face from a crowd of 10,000 people. We can easily sense the moods of other people.

These are all evolutionary mechanisms, high-speed inferences. And they work superbly well in areas with evolutionary precedent, areas that still resemble in some way the challenges facing early man, such as picking a mate, anticipating a rival’s actions, or selecting what to wear. (A New York celebrity fur designer claims that the world’s oldest profession is being a furrier!)

However, this system doesn’t work well in situations that are different from those encountered by early man. To put it more formally, when the operating environment has shifted from what the system was designed for, our evolutionary adapted mechanisms are no longer effective. In these situations, relying only upon our gut instincts will lead to failure, fully predictable failure.

Investing is one of those areas.

A Second Way of Reaching a Decision

Try to solve the following simple math problem: A baseball bat and ball cost $1.10 in total. The baseball bat costs $1.00 more than the ball. How much does the ball cost?

The problem is not really a math problem, it’s a psychological test. Because the answer, and our method of arriving at it, illustrates the limits of our intuition. If you are like most people, your immediate answer to the problem is the ball costs 10 cents. The majority of undergraduates at Princeton who were asked the question gave that answer. But that, of course, is the wrong answer ($0.10 + $1.10 = $1.20). The correct answer is the ball costs five cents. But to arrive at the correct answer, you probably had to pause for moment, for at least a beat, to think consciously rather than using your immediate intuition.

The fast and then the slow way of answering this simple math problem—each of which provides a different answer—illustrates that humans have at their disposal an additional method of thinking, a type of information-processing architecture other than intuition. Call it analytic intelligence or conscious decision making. This invokes rule-based decisions, nonsocial decisions that require abstract thought. This was the system you probably had to re...

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Adler, David E.
Published by FT Press (2009)
ISBN 10: 0137147783 ISBN 13: 9780137147786
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