The following is an excerpt (actually, it's Chapter 1) from Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes with Your Money, published FT Press.
In the summer of 2008, Rob Arnott’s research indicated there were problems ahead in the commodities boom. Arnott, founder of Research Associates, Inc., the giant Newport Beach-based money manager, is a quantitative investor as well as a contrarian who goes against the herd. His entire career has been built on finding ways to counter human emotions, including his own. His research but not his gut instincts told him that prices in commodities, including oil, had gone too far, and the future held more downside than upside.
This was not the conventional wisdom: Oil prices had surged by 300% between 2003 and 2007, and their climb upward seemed to only be accelerating. In 2008, prices crossed the once unthinkable $100 a barrel threshold, then $110, and finally brushed past $140 a barrel. Mainstream thinking held that the price increase was the result of changed fundamentals in the world economy. The newly awakened Chinese and Indian economies, with their nearly unquenchable thirst for raw materials, could only send the price of oil to higher and higher levels. Analysts who questioned if oil was in fact in the midst of an unsustainable price bubble were dismissed as bubble headed.
Arnott questioned his quantitative-based commodity. After all, the smart money, led by sophisticated institutional investors such as Harvard’s endowment, continued to pour money into oil. The continuing rise in price seemed to reinforce the wisdom of their decision. As Arnott admits, “I looked for ways to tweak the models, to fix them because the models were missing the huge bull market in commodities. That is what my intuition told me.” Arnott’s intuition, which was in conflict with the models, was wrong. The models had been right.
The price of oil soon crashed, but not before Arnott had sold his position. As an investor, he has trained himself to listen to his intuition—only to then do the opposite. “I use intuition, but in a warped fashion,” he says. If he feels comfortable about the direction his models are pointing him in, if they are in sync with his intuition, he immediately begins to worry.
He explains why so much of investing is nonintuitive: “The natural instinct is to follow others. As we were evolving on the plains of Africa, if everyone in the tribe starting running, you better start running. But in investing, if you act after everyone has starting running, you are catching the late end run of an asset and your timing will be atrocious.” For most investors, doing what comes naturally means chasing trends, doing what everyone else is doing. But although this makes sense in other areas of life, it is not a wise strategy for investing.
The easiest way for an investor to overcome this vulnerability is simply to build a natural skepticism to natural instincts. You don’t have to become a dogmatic contrarian—you just have to question your first impulse. Take, for example, a typical scene at a cocktail party. Someone brags about their fantastic investment. The natural reaction is to ask yourself if you are missing out on a great opportunity. The more skeptical and informed reaction should be to ask if the great past performance will continue into the future. Have you missed your window? Is it still attractive at current prices?
Arnott has trained himself to ask these counterintuitive questions when thinking about a new investment opportunity, and he feels everyone else can do the same. But he is merely one investor among many. And, the fact is, during the bubble years few investors showed this sort of skepticism—or any sort of skepticism. The entire world seemed intoxicated with money. It did seem like one big cocktail party, at least for people benefiting from the boom. With markets, as well as bankers’ bonuses soaring, why worry?
The cocktail party analogy holds a deeper truth about why investors may have suffered from impaired decision making and poor self control during these years before the crash. This was more than a simple case of minor intuitive errors in reasoning. Instead, according to MIT finance professor Andrew Lo, the real problem is traders literally were drunk on money. As Lo testified before Congress about the origins of the credit crisis:
“While this boom/bust pattern is familiar to macroeconomists, who have developed complex models for generating business cycles, there may be a simpler explanation based on human behavior. There is mounting evidence from cognitive neuroscientists that financial gain affects the same pleasure centers of the brain that are activated by certain narcotics. This suggests that prolonged periods of economic growth and prosperity can induce a collective sense of euphoria and complacency among investors that is not unlike the drug induced stupor of a cocaine addict....”
Lo, who is CEO of a hedge fund in addition to his work as an academic, has an interest in neuroscience. He has wired foreign exchange traders with biofeedback devices during the course of their work. When the market showed significant changes, so did the physiological response of all traders, but inexperienced traders were a lot more emotional when trading. For instance, they exhibited rising heart rates compared to the pros. For Lo, this indicates some emotion is necessary for decision making, but too much is problematic. (Neuroscience, though it has a different focus from evolutionary psychology, is consistent with and often supports the idea discussed throughout this book that humans have two decision systems—an intuitive one and an analytical one. Different responses exhibit different patterns of brain activation.)
I met with Lo at his office at MIT overlooking the Charles River. He was wearing sneakers, which made him look like either a trendy hedge fund manager or a down-to-earth academic. (Of course, he is both.) Lo explained to me how the way our brains are wired could lead to an economic crisis: “The situation had been building for 10 years. Everyone was making money all the time. Traders became confused because money was so cheap and risks were so hidden. Bond traders became caught up in a feedback loop.” It is Lo’s contention that the traders’ brains were affected by this loop. Financial success triggered the same neural circuits as by cocaine. Said Lo: “The same neural circuitry that responds to cocaine, food, and sex has been shown to be activated by monetary gain as well.”
As a result of their financial success, traders became inured to risk. In fact, they began to take on extreme financial risks—the financial equivalent of someone who is hallucinating stepping out of a 30-story building because they are certain they can fly. And to make matters worse, banks encouraged this risky behavior. Traders who refused to jump, were in effect pushed—or fired by their employers. Risk managers at large investment banks, in the months leading up to the crash, were sidelined or terminated if they warned the banks were taking on too much risk.
What this all suggests to Lo is the need for an external solution: a government intervention. If there is something hardwired in our cognitive processes that pushes us to excess, someone has got to stop us. Not everyone has the discipline to be a hyper-controlled investor and resist temptations that turn out to be damaging. Nor did financial institutions see any rationale to puncture the growing bubble. That leaves regulation as the mechanism society uses to prevent itself from indulging in self-destructive behavior.
Fire code regulation is a great example. Creating buildings with well-built emergency stairways, sprinkler systems, and clearly labeled exit signs is costly. This building infrastructure isn’t free. Why not leave it up to the market to choose which buildings are fireproof and which ones are not? Those worried about fires will pay more; those less worried will choose the second type of building.
Lo explained why, as a society, we haven’t left it up to the market to sort out this choice for us: “Left to our own devices, no would pay for the expensive infrastructure because when we walk into a building, our assessment of the likelihood of fire is zero,” said Lo. It is a cognitive bias. Intuitively, we underestimate the probabilities of this sort of catastrophe. But as a society, we have learned the hard way that people don’t worry about fires until after the fact. As a result, we put in regulation to ensure that buildings offer adequate fire safety.
The metaphor to financial markets and the crisis is clear. Here, we didn’t put in regulations to prevent banks from doing what they felt comfortable with in terms of risks. There was an inadequate “financial infrastructure” in terms of strong bank regulation and adequate bank reserves in place to protect the financial system in case of a catastrophe. Banks, left to their own devices, discounted this likelihood. They pursued aggressive trading strategies that seemed safe at the time, only to create conditions that led to a collapse in prices and an eventual fire sale of assets.
Errors in judgment, therefore, aren’t just ruinous to individuals: They can be damaging to society on the whole. A containable problem can quickly grow into something much worse—either a fire or a financial meltdown—if society chooses to ignore or discount people’s all too predictable biases.
Lo ended our interview on a poetic note, telling me that as a society, we need to look to Odysseus for guidance: “Just as Odysseus asked his shipmates to tie him to the mast and plug his ears with wax as they sailed past the Sirens of Circe’s island, we must use regulation as a tool to protect ourselves from our most self-destructive tendencies.”
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My conversations with Rob Arnott and Andrew Lo were really about the same problem: investor irrationality. Arnott’s strategy is squarely focused on improving returns, asking what is best for the investor. Lo’s arguments are more macroeconomic, asking how these biased individual decisions add up collectively.
Later, I will turn to the macro issue of the role intuition played in creating the conditions that led to the financial crisis. I then explore how to build a stronger financial system, given the way humans really think and behave, including the need for better regulation. More immediately, I now turn to specific investments and how in a time of panic, rather than engaging in an irrational flight to quality, there may be more profitable ways to invest. These behaviorally based investing strategies are literally “counterintuitive.” They require overcoming your own initial instincts and taking advantage of others’ rush to snap judgment about investment decisions.
and lists 17 common investing pitfalls and their remedies.
lists investing mistakes many people make as follows:
. They give some thoughts on how to survive a market decline (timely topic, huh?) as follows:
. 
by David E. Adler. This is a fascinating book about the psychology of money and how our instincts and emotions often harm us when we make investing decisions. The excerpt below is part two of a two-part series (part one was posted earlier today.)
. FYI, the levels referred to below are the various levels within the Sound Mind Investing strategy. Level 1 is getting debt free, Level 2 is saving for future needs, Level 3 is investing your surplus, and Level 4 is diversifying for safety.
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