Why Smart People Make Big Money Mistakes

"This is a wonderful book. The authors have a wonderful collective voice, and then each of them separately has a distinctive and informed voice. Tom Gilovich is one of the leading cognitive psychologists in the world. Gary Belsky is a sports journalist, although earlier he worked at Money magazine, where I once worked. You might think that being a sports journalist has nothing to do with financial decisions, but you’d be wrong. Anyone who is an informed sports fan knows perfectly well that there are a lot of analogies between sport and money management. That’s not just because it all seems to be about who is ahead and who is behind. It’s also about understanding the proper use of statistics, being aware of the strategy behind the scenes, and keeping in mind that who is on top is not necessarily who wins the championship in the end. This book seeks to explain a central puzzle in personal finance, which is, “Why don’t smarter people consistently have better financial lives?” On average, you would expect they would, and in many cases they do, but it’s far from universal. There is even some evidence that intelligence and investment performance may be inversely linked. There’s certainly not much good evidence that there’s a strong, consistent, positive correlation that smarter people are predictably better investors. And the reasons are clear. They come out of the fact that the limitations of the human mind aren’t correlated with intelligence. The same behavioural pitfalls trip everyone up, regardless of education, IQ or levels of experience. It’s only at extraordinarily high levels of expertise that some people can avoid these common pitfalls. This book does a wonderful job of explaining the basic principles of behavioural finance and the ways that some predictable limitations of the human mind have very clear financial implications. A lot of the book is based on the research of Daniel Kahneman and Amos Tversky, two Israeli psychologists who did their best-known research in the 1970s. They explored a number of persistent problems in human thinking, including the “law of small numbers”, which is a tendency of people to extract sweeping conclusions from very small samples of data. You can see why somebody who is interested in sport might pick up on this – because if a team in baseball or basketball wins three games in a row, it’s very hard for anyone to ignore the urge to conclude that the team is hot or on a roll, when, of course, it’s not actually that big a deal statistically, to win three games in a row. Even the worst team in the entire sport is capable of doing that on any three days. The same thing happens in financial markets. From a short streak, people will conclude the future is more knowable, and that it’s representative of how the investment is going to continue to perform. In fact, all it really is is a little burst of randomness and, all else being equal, there’s no reason to assume that it will persist. This is the kind of idea they explore over and over again, very beautifully in the book. Anybody can come away from reading it better equipped to spot these kinds of pitfalls in himself or herself. Yes, though it’s easier said than done. I wouldn’t want to give people the impression that all you have to do is read about it, and you’ll no longer be prone to it. Even psychologists who have studied these problems for a lifetime still go out and commit those errors of thinking themselves. But you can at least see it in yourself after the fact, and with luck, in certain situations you may be able to say to yourself, “Am I about to commit this kind of cognitive error that I just learned about?” Yes, and as someone who has written books like this myself, that is what you hope for as an author. That’s the ideal. But these biases of the human mind are very deep rooted. You don’t stand much chance of being able to avoid them unless you understand them – and one of the best ways to get to understand them is by reading a really good book about them like this one. It’s still no guarantee, but it certainly improves your odds."