Behavioral finance (along with behavioral economics) is the focus of many new books and articles today. The book Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes with Your Money, by David Adler, is an attempt by the author to explain what behavioral finance (and behavioral economics) is about and how an understanding of this field might be beneficial to investors and others.
Adler begins his book by claiming,
“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 interest.”
He follows this up by staying that "snap judgments and first impressions are poorly suited for calculating odds and probabilities, compounding interest, or forecasting the future behavior of the stock market.” As a consequence of this, he says,“Relying only on intuition in finance can lead to very bad outcomes, not only for individuals but also for markets.”
The basic contention of behavioral finance is that humans developed the skill of instinct and gut reaction as a survival mechanism that was very successful to the evolution of the species. Being able to react quickly to a situation was necessary for living another day, for finding the right place to find food, and for sensing the moods of other people.
However, as the human species survived and prospered, this method of reaching a decision did not prove adequate in all situations. So a second way of reaching a decision evolved, now labeled analytic intelligence or conscious decision making. This method is rule-based and is used in nonsocial decisions that require abstract thought.
And, this dichotomy represents the dilemma that modern decision makers face when presented with a choice. Which method of reasoning is the appropriate one for the decision at hand? And this is where Adler takes us in terms of financial decision making. “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 author begins his book by laying out the distinction between the two approaches to decision making. Once he has established the costs and benefits of each method he then proceeds, chapter by chapter, to examine how individuals default to their earlier instinctual responses in how they invest money in stocks, bonds, and other types of investment activities. After focusing upon investment decisions he broadens his perspective by discussing how we make decisions in life pertaining to personal safety, personal finance, health choices, and playing games and gambling. He has a whole section on the behavior of CEOs and another one on the psychology of the credit crisis.
The examples he presents are straightforward and easy to read. Of course, we can recognize irrational behavior in others. What David Adler would like us to be aware of is the irrational behavior in ourselves. And, this is the purpose of the book, to get us to realize that in a large portion of our lives we react instinctively to situations when we should act more analytically. We sell off the good stocks we own, holding on to those stocks that have losses and continue to tank.
Let me focus on just one specific chapter which, to me, brings out the essence of the dilemma Adler describes in the book. This is the chapter on “Value Investing.” Adler defines value investing using the following formula: invest in stocks that are under-valued or even cheap, stocks with low growth rates in boring industries, small caps that get little attention, stocks with no glamour at all. “The value proposition holds that these sorts of stocks consistently outperform the market portfolio and have lower risks than the market portfolio. This is one of the few investment strategies that has been shown to persistently outperform the market.”
There are many famous investors that have followed this formula to great success, such as Warren Buffett and John Templeton. Why, Adler asks, if this approach puts you “statistically” on the right side of the market in terms of historical results, don’t more people use it?
The answer is that this approach requires a cold analytical methodology and steely discipline, characteristics that most people, who rely too much on their instincts, don’t possess.
Adler gives us four reasons why most people avoid the value investing approach. First, value stocks don’t tend to have big payoffs. “Because they are boring, with real but limited growth, the market discounts them and they fall in price.” Second, most humans are risk averse. A cloud hangs over these companies. “Stocks that are cheap are ugly stocks, with depressing stories. People irrationally dump them because they want to dump the ugly stories.” Third, people are overconfident. People tend to overbuy stocks that are doing well and tend to believe that stocks that are not moving face certain trouble. Fourth, people prefer “compelling stories” rather than detailed statistics and thorough going statistical analysis.
In other words, success demands focus, hard work, determination, and discipline, especially the latter. In investing, and in many other areas of our lives, in order to overcome the primitively developed instincts that contributed to the survival of our species we must change the context of our responses and resort to decision making methods that are more abstract and methodical. In other words, we must become more rational.
This book represents an enjoyable read, an interesting read, and a helpful read. It presents an emerging field of analysis in a comprehensive way that is easy to digest. It is not the book to read if you want to understand the areas of behavioral finance and behavioral economics in greater depth. It is not the book to read if you want to become more sophisticated in your investing skills. But, it is a book that might encourage you to want to learn more about behavioral finance and behavioral economics, and it might encourage you to want to develop more sophisticated investing skills.