I can resist everything except temptation.
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 hunting 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.