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This chapter is from the book

Making Better Financial Decisions

That people aren’t always rational when it comes to financial decisions is clear, particularly after recent events. Everyone screwed up: sophisticated hedge funds and investment banks, as well as naive mortgage borrowers. The more interesting questions are: Why do we make these decisions, and to be more precise, when do we make them? Are they predictable? What can we do to make better financial decisions? How can we build a stronger financial system given how people behave?

The rest of this book describes ways to improve your decision making when it comes to specific issues in investing—and some areas in real life, too. Identifying circumstances where you should trust your gut versus situations where you need to do everything in your power to ignore it, is central to good decision making. The exact mechanism of how intuitive and analytical thought interact is unknown and is the subject of fierce debate among decision theorists. For Stanovich, the two types of decision systems can work together or in isolation, it all depends on what is being decided. Trusting your gut instinct is the way to go if the question has evolutionary precedent, such as “Do I recognize that face?” or “Do I love my spouse?” But if you are deciding which computer to buy, then an analytical approach is called for.

Financial decisions are more complicated. What makes investing so complex, as we shall see, is that although financial markets are primarily random and hence nonintuitive, not every manager’s performance is random. Some are better than others at beating the market. And there are some stock market patterns you may be able to spot intuitively that I will discuss in the book. However, they are few and far between.

The recent real-estate and credit bubbles, followed by the liquidity crisis, are extreme examples of what can go wrong when we privilege feelings over reason, particularly in a setting with few regulations in place to save us from our own worst tendencies. The gyrations of the stock market are particularly tempting to intuitive interpretations, and this is where individual investors, if they rely solely on their intuition for guidance, can face the greatest peril. But as we will see in later chapters, gambling in Vegas, football strategy, horse racing, and even a tennis game can be improved through a bit more conscious deliberation. TARP bailouts, securitizing a mortgage, setting limits on leverage, rating a collateralized debt obligation, and deciding whether to let Lehman Brothers live or die could also benefit from relying on analytical thinking rather than snap judgments.

The first part of this book focuses entirely on financial decisions. It includes advanced techniques used by very sophisticated investors who attempt to beat the market through an understanding of investor psychology. It spells out why these strategies work, and how they work. The parts that follow look at intuitive mistakes we make in real life outside of investing—in sports and gambling decisions, as well as healthcare and credit card choices. The next section analyzes CEO behavior, particularly that of Wall Street CEOs during the crisis. The final chapters examine the financial crisis from a behavioral economics perspective. The book concludes with ways to improve decision making, leading to better investing.

Good financial decision making doesn’t have to be complex or theoretical. You don’t have to train yourself to become the financial equivalent of an airplane pilot—you don’t have to fly on instruments alone and become a pure “quant.” All you have to do is to think beyond your first impulse. Don’t glaze over when facing a tough financial choice, or when presented with a supposedly unassailable computer model. Kick the tires of what’s in front of you, and ask if the information and your response to it make sense. It really couldn’t be simpler: When it comes to investing, have second thoughts about your first impressions.

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