Editor’s note: Adler’s latest book, “Snap Judgment” (FT Press, 2009), explores the behavioral roots of today’s financial crisis and ways to avoid a repeat.
Q . In your book, you explore how intuition, first impressions and “snap judgments” can be reliable in social situations, but deadly in the financial world. Why is that?
A. We evolved as humans to be able to make extremely quick, almost instantaneous snap judgments, because our lives depended on it. There wasn’t time for slower more deliberate decision making if you were chasing or being chased by an animal in the jungle. Intuition and first impressions also evolved to help us in social situations, to be able to evaluate if someone was a friend or enemy, and gut feeling are still useful for sizing up a new acquaintance.
The problem is our lives have evolved so much and now include complex math problems and random stock markets. You can’t solve a math problem by going with your gut, and to me, investing is similar in many ways to math in that it is highly numbers oriented. Here you have to make slower, more deliberative, more rational judgments.
What’s an example of an intuitive error that can impact individual finances?
Here is one simple intuitive mistake that impacts individual finances and that is looking at an investment on a pre-tax basis rather than after-tax. An investment may look fantastic pre-tax, such as a very actively managed mutual fund, or even possibly a hedge fund, but when you take taxes into account from all that buying and selling of stocks, the after-tax picture is a lot less pretty.
Taxes are boring. We also don’t pay them usually until after the fact. In other words, they aren’t obvious. What this means is we usually intuitively ignore them in our financial decision making when choosing among investments.
Unfortunately, many financial planners ignore them as well when constructing our portfolios. Have you ever gone to an investment advisor and had them tell you what the likely investment returns were after tax? Remember, it’s not how much you make, it’s how much you get to keep.
What is one thing investors need to do to protect themselves against a volatile market and panic-driven financial trends?
Investors need to hedge their portfolios in some way, particularly because volatile markets tend to stick around. No one foresees a return to the calm days of the Great Moderation (2003-2006) anytime soon. In the past diversification was the stock answer, but as we saw during the crash, simple diversification strategies didn’t work.
The easiest current hedge against both volatility and inflation is TIPs (Treasury inflation protected securities). But the returns are painfully low.
How can we avoid a similar economic crash?
Right now, there is no easy answer. The establishment of the [Federal Deposit Insurance Corp.] eliminated bank panics in the past. But the recent crash involved investment banks, the sums involved are too large for the government to insure, and so the system could be struck by similar panics in the future.
One good idea is to make the biggest banks — the one’s whose failure could pose a threat to the whole banking system — buy insurance against future crashes. This way, when the time comes, the government (i.e. taxpayers) won’t have to bail them out, there will be an insurance fund they contributed to for that.
