How snap judgment leads to poor investing

We’re not really hard wired for making money in the markets. We use a lot of gut instincts, heuristics and plain illogic in making decisions.  The result is sub-optimal investment performance. This is the nothing new as the field of behavioral economics has really moved to the forefront of academia with Daniel Kanheman receiving the Nobel Prize for his efforts. David Adler has a new book out called ”Snap Judgment” which does a very good job of giving some real world examples and advice that is helpful for professional money managers and retail investors alike.

The purpose of the book is clearly to identify specific ways our hard-wiring leads to poor financial decision-making and to give ways on how to recognize these situations and profit.  The book has five areas of concentration: Psychology in financial decisions, gambling, psychology in personal decisions, executive decision-making, and the psychology of the credit crisis.

What I found most engaging about the book was the anecdotes used to illustrate his points. 

Let me share a few with you.  The first deals with the way basic math intuition tricks us.  Adler gives a simple math problem to solve: A baseball bat and ball cost $1.10 in total.  The bat costs $1.00 more than the ball. How much does the ball cost? If you are like most people, your immediate (intuitive) answer would be 10 cents – but, of course, that’s wrong as $1.10 for the bat and $0.10 for the ball equals $1.20, not $1.10. So, to arrive at the true answer one must pause a second and work through the problem.  Thus, this simple example shows how intuition is often not enough when it comes to financial decisions.

Here’s another one.  Adler asks: Which of the following statements most closely coincides with your opinion of the Metallic Metals Act?  Adler goes on to present to suggest four answers before telling us that there is no and there never was a Metallic Metals Act. Yet, seventy percent of the people who were tested in a 1947 experiment picked one of the four choices.  Clearly, the suggestion that there was a Metallic Metals Act was so powerful that people fabricated reasons for its existence in their own minds.  The insidious thing about this second example is how difficult it is to realize that you have been tricked.

A third example I found truly remarkable is that most people were willing to take a sure $500 instead of a 15% chance at $1 million.  Adler gives a number of suggestions why this might be. But,the difference in payout is astronomical and the decision makes no sense whatsoever.

Obviously, we use heuristics or rules of thumb to simplify and reduce complex problems quickly in order to make snap judgments.  This facility may have been hugely important when we were in the wild looking to avoid being eaten alive, but it can be deadly in making financial decisions today.  And clearly, this is not just a case of retail investors making poor judgments.  So-called experts are subject to the same errors as Adler shows in his chapters on CEOs and the credit crisis.

And when some money managers are better than others at navigating the markets, ironically, this mere fact tends to pull their performance back to earth. Seeking Alpha is the holy grail of investing. But because we are all seeking alpha (looking for that risk-adjusted measure to identify how much a manager’s skill contributes to performance) and selecting our funds on that basis causes more money to flow into those funds. This drives up the price in their universe of assets and causes those assets to underperform.

So, what do we do as individual investors?  The first thing is to familiarize ourselves with the most common heuristics and their pitfalls. I’m talking about things like overconfidence, loss aversion, anchoring, the recency bias, and the scarcity heuristic.  This leads to things like excessive risk-taking, riding losers and cutting winners, and all manner of mistakes small and large.  Just knowing the biases or situations to look for is half the battle.

But, beyond that, I am not convinced we can do much else.  Adler does present a number of potential investment strategiesregarding dividends, value investing or annuities, for example.  However, it is not entirely clear to me that most people will be able to take on these suggestions without expending huge amounts of time and effort, something many of us do not have.

Adler also fails in his overarching theme of intuition versus analytics.  I found the dichotomy a bit forced and not at all additive to my comprehension of the issues. In fact, I often felt we could arrive at the same juncture making perfectly rational decisions.  It is not just a question of intuition and rationality but of market instability that is endogenous to the system. I found his formulation overly simplistic. So I took all of this with a very large pinch of salt.  The real positive in this book is in the specific examples and situations.

Overall, I did like the book.  It was a good read that used pretty straightforward language, making it accessible to virtually anyone.  Moreover, I found a number of the examples very real, and, thus, very powerful.  And I liked the fact that I could read almost any chapter without having to have read all of the previous chapters first.  So, this book is the kind of thing you can skip around in and still get the gist.  As long as you overlook the oversimplification in the intuition versus analytics theme, it is a useful book.

This is my fist book review in quite a while.  But, I hope to review more books in the near future.

  1. Wag the Dog says

    > But, beyond that, I am not convinced we can do much else.

    There is one other bias that works against you: illusory superiority

    More specifically (and more recently) there is the Dunning-Kruger effect in which the unskilled are completely unaware that they are unskilled:

    And if the unskilled are over confident of their abilities, they tend to be rewarded in competitive situations over their peers who possess a less inflated opinion of themselves despite having superior skills:
    Perhaps one source of the endogenous market instability is this tendency for the system to exaggerate confidence at the expense of accuracy.

    Dan Ariely comments: “These findings are troublesome. Because though confidence and accuracy sometimes go hand-in-hand, they don’t necessarily do so. And when we want confident advisors, some will exaggerate to give us what we want. Maybe this is why so many pundits on TV for example exaggerate their certainty?”

    So if over confident unskilled market makers were to read this book which, in your opinion, oversimplifies the cognitive biases, it may actually only server to reinforce their illusory superiority while failing to realize that even top magicians can still be fooled by the simplest of illusions. Indeed a little learning is a dangerous thing.

  2. Stevie b. says

    Ed – ok, I’m brave enough to say it took me a while to figure out your first anecdote – thank god i’ve no reputation to ruin!

    As far as heuristics and pitfalls and not being able to do much else is concerned, I think one over-riding strategy may have been overlooked – and that’s to do nothing for a helluva lot of the time. This may mean going into overdrive for a wee bit of the time, and even then that wee bit could could become a big bit longer if the timing was out. But basically, patience is indeed a virtue and waiting for the herd to provide value tilts the odds in the patient investor’s favour.

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