#511： Mastering the Psychology of Investing
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Summary
When it comes to investing, your brain can be your best friend or your worst enemy. Today, my guest explains how and what you can do to ensure your brain is a staunch ally in your quest for financial security. His name is Daniel Crosby, and he's a psychologist, behavioral finance expert, and the author of the book, The Behavioral Investor.
Transcript
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Brett McKay here and welcome to another edition of the Art of Manliness podcast. When it comes
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to investing, your brain can be your best friend or your worst enemy. My guest today explains how
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and what you can do to ensure your brain is a staunch ally in your quest for financial security.
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His name is Daniel Crosby. He's a psychologist, behavioral finance expert, and the author of the
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book, The Behavioral Investor. We've begun a conversation discussing the surprising ways
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sociology and physiology influence our financial decisions. We then delve into the psychological
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factors that cause us to make bad investing choices, including ego, conservatism, attention,
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and emotion. Daniel then walks us through ways you can mitigate those factors in your financial
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choices, and we enter a discussion outlining what an investing framework looks like based on the
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principles of behavioral science. While the principles discussed in the show relate to making
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sound choices in the area of financial investing, they're actually pretty relevant to making good
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decisions of every kind. After the show's over, check out our show notes at aom.is slash behavioral
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investor. And Daniel joins me now via clearcast.io.
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So we had you on a couple years ago to talk about your book, The Laws of Wealth. You got a new book
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out, The Behavioral Investor. It looks really cool. It's got this awesome inkblot bowl, which looks pretty
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badass. How is this book a continuation of The Laws of Wealth?
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So this is the graduate level version of, I think, The Laws of Wealth. The Laws of Wealth was my
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10 rules for getting your finances right, and it was sort of a paint by number. This book is
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admittedly a little more complex. And you know, I write in the first introduction there that my aim
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with this book was to be the most comprehensive look at the psychology of financial decision-making
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that had ever been written. And so that was sort of my audacious goal from the outset. So that's
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what I tried to do here is look at money and decision-making from every possible angle.
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Well, so you specialize in behavioral investing. This is what this book's about. For those who
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aren't familiar with that, what is behavioral investing? When did it become a thing? And
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what are the fields it brings together to do what it does?
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So you're right. It is an absolute mutt of a field, of a discipline. It sort of sits at the
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intersection of finance and behavioral science and sociology and psychology and decision theory
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and game theory. And so one of the things that I love about behavioral finance, which is sort of
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the name from my field, the proper name from my field, is that it does incorporate all of these
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things. And it's immensely challenging because there are so many fields and sub-disciplines involved.
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So you never feel like you quite get your hands around all of it. But to me, it's a really
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gratifying challenge. So it's risen to prominence in recent years because in the late 20th and early
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21st century, there have been a number of Nobel Prizes given out in behavioral finance and behavioral
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economics. So people like Daniel Kahneman and Richard Thaler and Robert Schiller have all won Nobel
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Prizes for their work. But the ideas that undergird a lot of what I'm writing about today go back to
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even biblical times. You know, there's references in Ecclesiastes to, you know, humility and
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diversification. It says in Ecclesiastes 11.2, invest in seven ventures. You do not know what
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disasters may come upon the land. And, you know, so I'm writing about some of these things through a
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scientific lens. But Shakespeare wrote about these things. They're written about in the Bible.
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Adam Smith wrote about animal spirits and the theory of moral sentiments in the 1700s.
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Keynes wrote about booms and busts in the early 1900s. So these ideas have been around for a very
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long time. But we're just now through the lens of science and with scientific rigor, starting to call
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them by their proper names and codify them and classify them the way that a scientist would.
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Well, one thing I noticed that behavioral investing does, and you spend the first part of your book
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discussing this, is looking at the ways our bodies, our brains, our psychology, our relationships,
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all these things, how they cause us to make bad or good investment decisions. So let's talk about
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like sociology, because that's something you wouldn't think of going to first, because people
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think, oh, it's a decision. It's personal. It's just me. Psychology, we were to start. But you talk
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about how sociology has a big influence on us as an investor.
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Yeah, so I think the person that's written about this most beautifully is Yuval Noah Harari, who
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wrote Sapiens and a couple of other wonderful books. But in there, Harari makes the point that
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the thing that differentiates us from the rest of the animal kingdom is not communication, because
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dolphins and chimps do that. It's not opposable thumbs. It's not tools, because crows use tools.
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The thing that differentiates us from the rest of the animal kingdom is we are able to believe in what
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he calls functional fictions. So these are things that are not strictly rationally true, but that
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serve a species-wide purpose. And so to make that a little more concrete, he says that money and
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economies are sort of foremost among these things. So everyone that's listening to this show spends most
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of their day toiling away for these pieces of little green paper or numbers in their bank account that
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have no intrinsic worth aside from the worth that we have ascribed them as a society.
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And so he says this is where we differ from the rest of the animal kingdom is that we, you know,
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we can create states and constitutions and economies and things that aren't literally true,
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that don't have a basis and objective fact, but still have collective utility and collective truth
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by virtue of our group agreement upon these rules. And so we learn that in a very real sense from the
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time we're born, we believe in stuff that's not true because it's expedient. And so that's done great
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things for us as a species, but it means that we tend to reason not in rational terms, but in group
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terms. And when you apply that sort of herding behavior, that crowd mentality to something like trying to
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choose a good stock or trying to time the market or, you know, decide how to invest that same
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tendency that serves us very well when we're setting up a nation or a church serves us very poorly as
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investors. My favorite bit of research on this in the book talks about this Ash experiment, which is an
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experiment that was done, you know, 50 years ago plus where they had people look at three different
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lengths of lines and they had, you know, a group of lines on the left and a group of lines on the
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right and say effectively, you know, which, which line on which, excuse me, one line on the left and
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then a group of lines on the right and say, which line on the right looks the most like the line on
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the left. Well, what they would do is they would put people in groups so that confederates of the
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experiment, six or seven people would go before and give the wrong answer. And so by the time they
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get to the last person, 76% of the time, the last person who was not in on the joke, not in on the
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experiment would also give the wrong answer. Now we used to think that this was just a simple
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matter of peer pressure. But brain science, now we're able to observe what happens in an experiment
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like this. When we monitor brain activity with an fMRI, we find that this person's the parts of their
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brain that are lighting up during this experiment are those that are associated with sensation and
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perception. So the groups thinking that the wrong line was, was the match actually changes the way
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that last person physically sees it. They're not just getting pressured into doing something
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different. They're actually seeing it differently than it is because the other people in the group
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disagree. And so we have to understand this as investors, that other people's opinions of a
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market of a stock actually can warp our perceptions in real ways.
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No, I thought that's powerful. I've experienced that. I think if you grew up in the 80s and 90s,
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you probably experienced this with baseball cards. That's a perfect example. I was convinced when I was
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12 that I would pay for college in my retirement with my baseball card collection. And now it's in my
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Yeah. So the baseball card bubble has been well documented. There was also a really profound
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bubble, I think a few years later in Beanie Babies. And there was a book written on the
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Beanie Baby bubble that is like an absolute thrilling must read. And the guy that was in
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charge of, you know, the guy that invented Beanie Babies was like this salacious character and,
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you know, just doing all kinds of shady stuff. But, you know, we had the Beckett monthly,
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right? You remember Beckett, you would get your monthly thing and you would check. It's the
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equivalent of a Bloomberg terminal for, you know, for little kids in the 80s where we would sit there
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and every month it only went up, right? You know, your Frank Thomas card or your Ken Griffey rookie
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card or your Jose Canseco card only ever went up. And you had these positive feedback loops with the
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Beckett magazines. And then we had a glut of supply. You know, it used to be just tops, but then you had
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Fleer and Donruss and Upper Deck and all these late entrants when this started to take off.
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So yeah, the things that were present there, you had this collectivist mentality. Every person our
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age thought that they were going to go to college based on their Ken Griffey rookie card. But we're
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comparing that, you know, to a time when the Hannes Wagner card came in tobacco packs and, you know,
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they had to shut them down because people got upset that they were selling cigarettes to kids
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basically with these cards inside. So they're extremely rare. And you contrast that with a
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time when you've got, you know, a new baseball card startup popping up every other year.
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So these feedback loops, like I just talked about, precipitated this bubble. And you see
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that that collectivist mentality was a lot of what propped it up until we no longer agreed that they
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were worth what we thought they were worth. And you're seeing something similar with like
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cryptocurrency, right? Like there's a two years ago, there's a huge spike in Bitcoin, but now there's
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all these other cryptocurrencies and the market's still trying to like, the group's still trying to
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decide like, what's this thing worth? And no one really knows yet.
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Well, you know, cryptocurrency is a great example and everyone loves to dump on cryptocurrency. But the
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thing is, our fiat currency, you know, our money is really no different than cryptocurrency,
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except perhaps at this point in that it's backed up by big guns and big governments. But, you know,
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cryptocurrency is a perfect example of this. You know, it was to whatever Thanksgiving last,
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it was worth $20,000 a coin because that's what people thought it was worth. And today it's worth
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whatever, $3,000 or $4,000 because some of that trust has been eroded and people no longer have this
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sort of collectivist consensus around this. And so we need to understand that, you know,
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you don't find stock prices, you don't dig up stock prices from the earth, and they don't have an
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objective reality. They're worth what we all think they're worth. And understanding that human tendency
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is a powerful first step towards being a good investor.
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So another part of our self that you wouldn't think would influence investment decisions or financial
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decisions is our physiology, right? Like our body can actually influence our decisions. Talk about
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that a little bit. Yeah. So I think this one is perhaps the most ignored. And it's a little bit
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candidly discomforting to learn about how central your body is to the way that you think about the
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world. Because each of us has this subjective sense of being in control. Like, you know, being in
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control, we're making good decisions based on the available information. And these decisions are more
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or less objective. But in my research, I found a lot that sort of speaks against this strongest form
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of free will and talks a lot about how our bodies have a huge impact. So, you know, a couple of
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examples are, there's been research on the power of music. And so when liquor stores play French music,
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the consumption of champagne goes up 75%. When they play German music, the consumption of German beer
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goes up 50%. When they play music, classical music on the tube, violent crime drops dramatically.
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So there's all these things that like what's going on in your body and your surroundings has a ton to do
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with the way that you make decisions. And I cite a famous study in the book that talked about Israeli
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judges. And it found that the best predictor of the harshness or the leniency of an Israeli judge's
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ruling was how recently they had eaten. So, you know, the further they were away from a snack or a
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meal time, the more punitive they became. And so we're talking about the best educated, the upper
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crust, the intelligentsia of one of the most technologically advanced, great civilizations the
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world has ever known. And the smartest 2% of Israelis are making decisions after, you know, eight years of
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college based on how recently they've eaten lunch. But I promise you that if you ask someone who's
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coming out of a liquor store, you know, why did you buy that beer? Or you ask an Israeli judge, why did
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you throw the book at this prisoner? Neither one of them is going to say because of these subtle bodily
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cues. And yet that's what the research tells us. And so it's a little unnerving to learn how sort of
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fickle we are and how fallible and how quickly we can get moved away from this sort of homeostatic set
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So you could like be hungry and decide to sell all your stock and go all in on something else just because
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Absolutely. That's absolutely plausible. And I mean, I think, you know, there's, you know, substitute hunger
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for myriad other emotions, you know, upset with your spouse, you know, didn't sleep well the night
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before, you know, two nights of missed sleep is the equivalent of a hit of acid. So I mean, all of these
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things impact our decision making in really, really powerful ways. And so let's say you got a young, you
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know, a young kid in the house, I got, you know, I have a young son who wakes me up just about every
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night. And he's really messing with my investment decision making, right? You all these, you know,
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all these sort of very quotidian everyday factors, like how recently you've eaten, you know, how your
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kids are sleeping, all of this kid could wreak havoc on the way you manage money.
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Well, and this is the art of manliness, testosterone, I think they've done studies on that. Testosterone has a
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big influence on how stockbrokers make investment decisions. Like if they have higher levels of
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testosterone, they take more risks. That's what testosterone does.
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Yeah, there's a great book by John Coates. It's called The Hour Between Dog and Wolf. That's all
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around his studies of testosterone on traders on the floor of stock exchanges back when we did that,
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you know, had open outcry markets. But what they found was that testosterone increased in winning
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traders. So like you're on a hot streak, you're trading, you know, you're trading your face off,
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you're doing great, you're, you know, compounding your money, doing great. Testosterone increases and
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increases and increases until we take dumber and dumber risks. Like for a while, it's helpful.
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You know, this increased level of testosterone is actually helpful. It makes you, you know,
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your sense is more acute. It makes you sharper and more confident. But then at some point,
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it spills over into overconfidence. And he talked about observing this in the animal kingdom as well.
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You know, rams and different animals who would, you know, fight for a mate. They would win a couple
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of matches in a row. They'd win a couple of, you know, these head-to-heads in a row. And then they'd
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start taking stupid risks. And so, yeah, it's a real consideration. And, you know, at the risk of
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being booed off the art of manliness stage here, women on average are much better investors than men.
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Part of it's the way that they're socialized, but part of it's genetic. I mean,
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part of it's biological, physiological. And maybe like it's why older men do better too,
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like a Warren Buffett type. Like he's probably doesn't have the testosterone levels of a
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25-year-old Warren Buffett. Well, the worst, the worst traders are young, unmarried men.
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The best traders are married, older married women, and then older married men are just behind them.
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And I think that that has a lot to do with it. All right. So our sociology can jack us up. The people
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we associate with, the group can mess us up. Our physiology can influence our decisions. Sometimes
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good, like the testosterone can be good, but at a certain point, it's diminishing returns and
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actually negative returns. Let's talk about the psychology. And you talk about there's four
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factors in our psychology that can cause us to make bad investing decisions. There's ego,
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and there's conservatism, attention, and emotion. Let's start with ego. So first off,
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like, what do you mean by ego? Because people have different ways of describing that. And then
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how does our ego cause us to make bad investment decisions?
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Yeah. So ego in this case is not like ego in the Freudian sense. This would be ego in the sense of
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overconfidence. So overconfidence, again, research suggests men are more prone to overconfidence than
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women, especially with respect to money. But overconfidence takes a couple of forms,
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cup three, to be exact. So overconfidence, we tend to think we're luckier than other people.
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We tend to think we're smarter than other people. And we tend to think that we can forecast the future
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better than we actually can. And so if you think about each of these, the luckier thing,
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people tend to say, if you ask someone, what are the odds of you getting divorced? They'll say,
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oh, never happened. What are the odds of you winning the lottery? Like, oh, well, maybe.
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And we see this across contexts that when we ask people about bad things, they dramatically
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underestimate the risk of bad things happening to them and dramatically overstate the probability of
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really positive things happening to them. So this systematic sort of misapprehension of the world
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leads us to take outsized risk, leads us to do all sorts of dumb things because we think it can't
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happen to us. The second piece there is just thinking we're better than other people. We're smarter
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than other people. There's great research that the last paragraph of this research said that the
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average man thinks that he's two sit-ups away from dating a supermodel because they found that 90 plus
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percent of men think they're friendlier than average, smarter than average, and more athletic than
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average. And so we all think we're better than we really are. And the thing about this and a theme
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throughout the book is that this serves us very well in many respects, this overconfidence. I mean,
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it helps us bounce back from tough times. It helps us bounce back from rejection. It gets us out of bed
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in the morning. It leads us to approach the girl at the bar that we probably have no business talking to
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and we end up marrying. There's a lot of good stuff that comes from overconfidence and a rosy look
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at the world, but you can't bring it to the world of investing. And that's just a theme you see again
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and again in the book is, look, this stuff evolutionarily exists for a reason, but Wall
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Street is a different animal and you have to leave this overconfidence to the side.
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I mean, so how does that manifest itself that you've seen where there's overconfidence amongst
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investors? Well, one is day trading. People just thinking they can go it alone,
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thinking they can go it without any real education or any assistance from a professional
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over trading accounts. I see a lot of people holding two large positions in a single stock.
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All of this is ego, right? Because they think, well, I know something. I have insider information.
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It's not going to happen to me. I talked to a gentleman at a conference who had $2 million.
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He came up to me and was like, look, I have $2 million. Half of it's in a diversified portfolio.
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Half of it's in this single stock. What do you think about the prospects for this single stock?
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And I was actually incredibly bullish on the stock at the time and it's done very well since.
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But I told him, I'm like, you have to sell this. You have to diversify away from this position
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because you can be right and still be a moron. And good investing, good behavioral investing
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is about playing the probabilities. It's like playing cards. You tilt probability in your favor
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at every turn and you never make an outsized bet that can ruin you. So even if that, I have no idea
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what he did with that million dollar holding in a single stock. But even though it's gone up since
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then, I hope he sold it because that was the right thing to do. That's how you win as a long-term
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investor by tilting the odds in your favor, not by getting lucky. We're going to take a quick break
00:21:11.100
for your word from our sponsors. And now back to the show. Well, I thought another key takeaway for
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me on this section about ego is that particularly in regards to the stock market is that we actually
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become more egocentric. And by egocentric, I mean like we have overconfidence when there's more
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complexity in our environment. And like the stock market, it's like one of the most complex things
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out there because it's just, it's all based on groups of people trying to decide the value of
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this fictitious thing out there. Yeah. So you make a great point. And one of the,
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you know, there's so many paradoxes about human nature as they butt up against the stock market.
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But one of them is that the more complex and dynamic a system is, the more simple your solution
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needs to be. So this is, you know, profoundly counterintuitive. We think, you know, that the more
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complicated a system is, the more dynamic it is, we need complex dynamic rules to beat it. And the
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opposite is true. And I talk about this in the book. So yes, the stock market is enormously complicated.
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It has effectively an infinite amount of inputs. And because that is the case, you will never,
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ever figure out, you know, the rules. There will never be a perfect formula. And accordingly,
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the people that tend to do well in the market tend to follow a handful of simple rules. You know,
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they don't try and time it. They automate their decisions and they kind of let it run. And it's
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not a sexy thing. It kind of flies in the face of where we want to be. But because the market is so
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complicated, for that very reason, your solution necessarily needs to be simple.
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And I imagine the folks who come up with complex solutions, because the solution is so complex and
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they feel like they thought this through a lot, they're going to be more certain of their solution,
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even though it's probably the wrong solution. Well, there's great research on that. They talk
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about betting, you know, betting in college sports and how folks do if they're given, you know, let's
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say I'm from Alabama. So let's say Auburn and Alabama are going to play. And, you know, I give you
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four variables. You know, I give you the average weight of the offensive line and, you know, a couple other
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variables, right? And then they ask people to bet on the outcome of the game. So they do this with
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four variables, eight variables, 10 variables, 25 variables. So people's ability to predict the
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outcome of a game is flat across all those variables. But their confidence increases with
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the complexity, increases with the number of variables. So people with four pieces of information
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are no better at guessing who's going to win that football game than people with 25 pieces of
00:23:53.500
information. But they're much more confident in their ability to predict it and accordingly
00:23:58.480
take more leveraged bets, take bigger bets, take stupider bets. And, you know, the same thing is true
00:24:04.800
in the stock market. You see some of the brightest people around have figured out complicated systems to
00:24:11.700
try and master the market. But what has invariably happened to them is that they've blown up.
00:24:17.240
You know, they've blown up. They'll do well for a time and then they blow up. Look up long-term
00:24:22.220
capital management or any number of others. And so the complexity becomes the undoing in the long
00:24:28.980
term. And the complexity is also, just as you said, the very thing that leads them to take stupid bets
00:24:34.760
in the first place. You know, another thing that I like to tell people to do to try and mitigate this
00:24:39.900
overconfidence is to define the problem as precisely as possible. Because when the question is
00:24:47.060
vague, you know, when you ask people, you know, are you smarter than average? Almost everyone says
00:24:53.100
yes. Because smart is kind of this vague thing. You know, some people think it looks like street
00:24:58.420
smarts. Some people think, you know, it looks like having an advanced degree. There's not much
00:25:03.340
agreement on what smart is. And so most people go, yeah, I'm smarter than average. But if I ask you,
00:25:09.280
are you a better oil painter than most people? You know, then you go, oh, well, no. You know,
00:25:16.000
I'm definitely not a better oil painter than most people. And so the more precisely you can define a
00:25:22.740
problem, the more likely you are able to be to sort of match your own skills up against your ability to
00:25:30.000
Well, besides that, is there anything else that you can do to mitigate the downsides of ego when
00:25:36.740
So in investing, I mean, the easiest way to manage ego is to just diversify, you know, to diversify
00:25:43.340
across a number of different asset classes. And then, you know, with within each of those asset
00:25:48.180
classes to make sure your holdings are diversified within and across asset classes. Because diversification,
00:25:55.540
we've all, you know, we've all heard about it as, you know, don't keep your eggs in one basket. And
00:25:59.700
that's right. That is what it is. But psychologically, you're basically saying,
00:26:05.060
I don't know what's going to happen. You know, diversification is effectively saying,
00:26:10.540
shrugging your shoulders, right? Saying, I have no idea what's going to happen.
00:26:14.260
I have no idea if stocks or bonds or real estate or gold or, you know, whatever other thing is going
00:26:20.360
to be the next big winner. So I'm just going to own them all. And so that is one of the most humble
00:26:25.320
things you can do. And it's not sexy, but it, but it works. And then, you know, the last thing I would
00:26:30.220
say is to become a teacher. I follow Richard Feynman's admonition here, the great physicist.
00:26:37.020
And he used to ask people this sort of cheeky question. He would ask people, you know, do you
00:26:42.140
know how a toilet works? And, you know, everyone's like, yeah, I mean, I know how a toilet works. Like
00:26:47.620
I use a toilet a couple of times a day. So yeah. And then you go, okay, well, great. Teach me how a
00:26:52.680
toilet works. And then people would stutter and stammer and, you know, realize they had no idea
00:26:57.560
how a toilet works. And so, you know, for me, the process of writing books is one of the ways that
00:27:04.340
I keep myself in check because when I try to tackle these big problems and write, write these
00:27:09.440
comprehensive books, I end up, you know, finding the holes in my logic, the gaps in my understanding.
00:27:16.200
And so becoming an educator on these things, trying to teach, you know, a friend or a spouse
00:27:22.500
about finance is one way that you're going to realize you don't know as much as you perhaps
00:27:28.500
Or if it's really hard to explain your investment strategy to your 13-year-old daughter or son.
00:27:34.420
That might mean you need to do something different.
00:27:37.280
So the other psychological factor that can get in the way of us making good decisions is
00:27:43.400
So conservatism is the tendency for us to confuse what we're familiar with, with what
00:27:50.060
is safe or desirable. So you see this in a couple of ways. You know, the first way is
00:27:55.520
that people tend to dramatically overinvest in their company stock. A second way that we
00:28:01.920
see this is, you know, by geography. So, you know, people in the Northeast, Northeastern
00:28:07.060
U.S. tend to be very overweight financial sectors and people in the Midwest tend to be
00:28:12.920
overweight agriculture stocks, say. And so we also see this on a national level. You
00:28:18.780
know, I spent three months in Canada last summer. I lived in Western Canada last summer and it
00:28:24.280
was absolutely gorgeous. Can't wait to go back. But, you know, Canada was interesting
00:28:28.900
because there are about 4% of global GDP comes from Canada. And yet the average Canadian had
00:28:36.680
about 65% of their wealth in Canadian stocks. And so the reason they did this is because they
00:28:43.540
knew them and they thought by virtue of them knowing, you know, knowing about these companies
00:28:48.040
that they were safer or better. But a good rule of thumb is to own stock in relative to proportion
00:28:54.440
to its, you know, share of the equity pie worldwide. So the U.S. is just over half. So, you know,
00:29:01.600
as a good rule of thumb, about half of your stocks should be in the U.S. and the other
00:29:07.340
half should be international. So, yeah, we see this all over the place, though, where it's
00:29:11.880
like, because I know it, because I'm familiar with it, therefore I'll invest in it. And it's
00:29:16.840
actually quite dangerous. And, you know, we saw during the Greek debt crisis, you know,
00:29:21.580
Greek is some teeny tiny percentage of the world economy. And yet Greek investors had a majority
00:29:27.480
of their wealth in Greek stocks, and it ended very poorly for them. So something we have to be aware
00:29:32.780
of. And I imagine too, this can get in the way. It's like, it's that loss aversion, right? So like,
00:29:38.740
as soon as we own something, like it's ours and like, we don't want to lose it, even though it's
00:29:43.100
like, it would make sense just to get rid of it. So like you buy a stock and it's doing terrible,
00:29:48.280
you don't want to dump it because like, that's the devil, you know.
00:29:51.080
Yep, absolutely. There is a, there's a real devil, you know, factor. So, you know, you're,
00:29:56.280
you're talking about loss aversion and also endowment effect, which is this,
00:30:00.420
this idea that by virtue of owning something, it becomes more valuable. You know, this is why people
00:30:05.840
have trouble selling their houses or, you know, selling their junk at a garage sale.
00:30:10.360
Because we think just because it's ours, you know, it's, it's worth more than,
00:30:14.680
than the market will bear. That's a very, very common tendency. And the reason this is so dangerous is
00:30:20.160
because it basically, you're stacking risk. So, you know, I live, I live here in Atlanta
00:30:25.480
and so let's say I live in Atlanta and I work for Coca-Cola and I, you know, I invest in Coke stock,
00:30:32.880
you know, heavily through my personal investing. And then I invest in Aflac and UPS and other,
00:30:39.180
you know, Cox Communications and other local companies because I know them and I have friends
00:30:43.360
there. So they feel like known entities to me. Well, if the Atlanta economy hurts, if something
00:30:49.560
happens to Coke and people stop drinking, you know, as many soft drinks, my, my house value goes down,
00:30:55.160
my stocks go down, I may lose my job and my local economy is impacted. So you're like quadruple
00:31:01.160
loaded when you do this, when you fall prey to this conservatism bias.
00:31:05.720
And we can become more conservative based on our environment. So I think they've done,
00:31:09.300
you highlighted studies when like the stock market is going down, like people like,
00:31:14.540
like stop, like stop investing in the market. They might even sell and they just go put everything
00:31:20.100
into cash or bonds or gold or whatever. And it's just because the group decided, well,
00:31:26.340
it's not as, the stock is not as worth as much as we thought it was.
00:31:29.780
Yeah. It's, it's fascinating because I'm, I'm one of my big projects at work right now is developing
00:31:35.040
this tech simulation of the stock market, basically a stock market game that, that monitors people's
00:31:40.540
behavior and tries to make inferences about how to keep them from, from making bad decisions.
00:31:46.400
And what you see again and again is people do the exact opposite of what they should do.
00:31:50.640
You know, when the stock market has run up, you know, for years at a time, they go, okay, now let's get,
00:31:56.200
you know, now let's take some risk. Well, at that very moment, it's riskier than it's ever been.
00:32:02.160
And then when the market crashes, they go, okay, let's take some risk off the table.
00:32:05.800
So, you know, Howard Marks, this billionaire famed investor calls this the perversity of risk,
00:32:12.140
which is that risk is, is most felt when it is least present and it's least felt when it's most
00:32:18.000
present. So it's a tricky paradox again, but just about the moment you're starting to feel safe,
00:32:24.200
you should start to worry. And just when you're at your period of maximum worry, you should start to,
00:32:30.840
But the thing is though, is like, that's hard to figure out, right? Like you don't know,
00:32:34.440
it's like, okay, is it going to, this, this rally we're having, like we had like that big
00:32:38.320
bull market going on for, you know, and it started going down in July. You're like, oh,
00:32:43.100
should I, should I sell now? Like, is this the point? I mean,
00:32:46.380
Yeah, it absolutely is. And you know, the thing is it will never,
00:32:51.000
it will never really feel safe. I mean, when you look back over, you know, a hundred years of,
00:32:56.780
of the S and P or the Dow, there's always been a reason not to invest. I mean, you look at,
00:33:02.080
well, you know, Warren Buffett's lifetime where he's compounded his wealth so extravagantly,
00:33:06.300
you know, there have been numerous world wars, there've been flu outbreaks, there've been pandemics.
00:33:11.460
I mean, there's just been political scandals. I mean, there's always going to be a reason to worry.
00:33:16.800
And we always think that our time is sort of uniquely bad. And, you know, this is cutting to
00:33:22.540
the chase. This is where I think that one of the biggest tools in a behavioral investor's arsenal
00:33:27.320
is automation. You know, just being able to take the decision-making process off the table,
00:33:33.020
having some solid rules about investing consistently, escalating those investments as
00:33:37.900
your, as your income grows. And frankly, just worrying about more important stuff because,
00:33:43.040
you know, life is, is much more than the things we're talking about today.
00:33:46.600
And the sooner you can automate these things, you know, the happier you're going to be and the
00:33:51.980
All right. So the, the, the, to counter out conservatism, just put your investment on autopilot.
00:33:57.460
Yeah. Yeah. Put it, put it on autopilot. You know, another thing you can do is to take away
00:34:02.500
the fear of loss. You know, I talk, I talk in the book about a Hyundai, Hyundai, the carmaker
00:34:07.680
program during the great recession, you know, automakers were getting destroyed and Hyundai says,
00:34:13.560
you know, what can we do to sell some cars in this awful environment? They, they started a program
00:34:19.320
that said, you know, buy a Hyundai. And if you lose your job, we'll buy it back at full price.
00:34:25.280
You know, we're going to buy it back at full price. And they had an 8% increase that year
00:34:30.740
in a horrible market. You know, everyone else was getting killed and they were up 8% that year
00:34:36.120
in terms of their sales, because you took the worst case scenario off the table.
00:34:41.360
So this is, you know, this is something that me and my wife do once we passed, you know,
00:34:45.700
sort of our first significant milestone, our first significant financial milestone, we said,
00:34:50.780
look, we don't want to go back from this place. You know, so we have a bucket of money and a safety
00:34:56.900
bucket and it's, you know, candidly not getting market returns is getting two and a half, 3%
00:35:01.780
and has been for a couple of years, but it helps us sleep well at night and it takes away the fear of
00:35:07.800
loss so that we can be more aggressive with, with some of our other assets. So that's another big one.
00:35:14.460
And then finally procrastinating. We're much less likely to, to rely on the status quo or to do
00:35:21.300
what's always been done. If we sleep on it, we're about 30% less likely to just take the default
00:35:26.880
option. If we just take a day, think it over. So never get pressured by a financial salesperson.
00:35:33.620
Never make a big decision about your money in a hurry. Always take that day, that 24, 36 hours to
00:35:41.040
sleep on it, think on it, and you're going to be much less likely to, to fall prey to this.
00:35:46.000
Yeah. The bucket strategy sounds like Nassim Taleb's barbell strategy.
00:35:49.640
Right. Where you have one, you have one, like a bit like 10%, like in just CDs, bonds,
00:35:55.200
like the safest thing you could possibly have. And, or no, it's like most of it's in CDs and bonds.
00:35:59.500
And then you use 10% to take, and he's like a hedge fund guy. So he's like taking like big time risk.
00:36:04.020
And so the downside, like it mitigates the downside, but the upside is really great if it works out.
00:36:09.680
Yeah. Yeah. There's, there's really something to it. I use, I use sort of three buckets. I have like
00:36:14.380
safety, you know, a safety bucket, a, you know, a market bucket, and then a sort of shoot the lights
00:36:19.800
out, drive a Bentley one day bucket. So, you know, these are, these are sort of my three,
00:36:25.160
but that safety bucket is such peace of mind. And I mean, it's not, again, mathematically,
00:36:30.640
it's not optimal. You know, I'm getting suboptimal returns on that. But one of the
00:36:35.200
things you learn when you study behavioral investing is the best portfolio is the one
00:36:40.780
that you can stick with. So let's talk about attention. The stuff we pay attention to in
00:36:45.460
the world can influence our decisions. How so? Yeah. So attention is all about this human tendency
00:36:51.500
to confuse what's scary and lurid and vivid and newsworthy with what is likely, you know? So
00:36:59.120
the silliest example that I cite in the book was that many, many times more people died last year
00:37:05.360
of taking selfies than died in, in shark attacks. And yet, you know, we're very scared of sharks and
00:37:12.640
we're, you know, not, not all that scared of taking selfies. And it's because we just don't think about
00:37:17.920
the world in probabilistic terms. You know, the things that we hear about on the nightly news
00:37:22.440
are what scares us. You know, odds are that you and I are going to die of, you know, cancer or heart
00:37:29.300
attack or something. And yet here we are, you know, worried about terrorism and crashing in a
00:37:34.540
Boeing 737 and, you know, all kinds of things that are statistically unlikely. And yet, you know,
00:37:40.580
I'm going to go eat a hamburger tonight and, you know, bring myself closer to something that's very
00:37:46.000
likely like a heart attack. And so part of becoming a behavioral investor is learning to think in terms
00:37:52.700
of base rates, to think in terms and assess probability on the terms in which it actually
00:37:58.900
happens and not just on the terms in which you can recall it.
00:38:02.120
But it sounds like the way the attention can infect our investing is like, you just remember the bad
00:38:06.600
things that happen. Like if you're a millennial, you just remember the great recession. You're like,
00:38:09.940
well, that sucked. I'm not going to invest in stock anymore. If you're a greatest generation guy,
00:38:13.820
you remember the great depression. It's like, well, I'm going to put all my money under the
00:38:17.760
mattress, but you ignore like all the other times where things were great in the stock market.
00:38:23.180
Yeah. So that is a, that is a, an absolutely fantastic example. So, you know, you look at
00:38:27.900
someone like me. So I got out of grad school in 2000, in 2008. So, you know, I get my first,
00:38:35.000
you know, big boy job in 2008 and I start saving and immediately it's just crushed, right? You know,
00:38:41.360
immediately whatever meager sum I had put aside was halved because, because of the great recession.
00:38:48.520
And so, you know, there's something in psychology called a primacy and a recency effect where we have
00:38:53.420
a better memory for, for events that happened to us early in a sequence and late in a sequence.
00:38:58.920
And so we tend to be overly influenced by things that happen early in our investing lives and things
00:39:04.420
that have happened recently. And so, yeah, someone like, you know, you think about Q4 of last year,
00:39:10.960
we had such a choppy market in November and December. So someone my age in Q4 of last year
00:39:16.840
is going, well, look, I got into the market, I got crushed. Here we are again, it's getting crushed.
00:39:22.960
All this stupid market does is go down, you know, ignoring the fact that it's up 400%,
00:39:28.600
you know, in, in that, in that intermediate period.
00:39:32.060
So that's the tension at work is these big high profile events sticking in our minds and looming
00:39:39.020
larger than life than the actual numbers and the actual reality.
00:39:44.780
So, you know, there's this idea of, of base rates, right? Which is just planning around
00:39:50.520
probabilities. So if you look at some of the probabilities in the market, the market in the
00:39:55.720
last 35 years has dropped 14% a year on average. Okay. So on average, there has been a drawdown
00:40:04.340
sometime in the year, uh, from a, from a, from a peak to a trough of 14%. And yet every time we have
00:40:12.300
an eight or 9% drop in the market, CNBC has a markets and turmoil special. We're freaking out.
00:40:18.480
Like we've never seen this before. And it happens as regularly as, you know, Christmas and your
00:40:24.840
birthday. I mean, it, it happens all the time. It's because people have forgotten about base rates.
00:40:30.860
So I think one of the things to do is become, uh, you know, become a bit of a market historian to,
00:40:36.140
to know what average looks like. You know, I think about, cause I think about this with marriage too,
00:40:41.840
you know, if you ask someone on their wedding day and you really shouldn't do this, but if you,
00:40:46.900
if you ask someone on their wedding day, you know, what's the likelihood of you getting divorced,
00:40:52.080
if they're honest with you, they should say, well, you know, 50, 50, 50. And yet we, we don't think in
00:40:58.380
those terms. And because we don't think in those terms, we don't prepare adequately. And we don't
00:41:02.920
maybe treat marriage with the, with the care and the, you know, the, the care that it deserves.
00:41:09.160
And the same is true of markets. If we knew the odds better, we'd know better. Uh, we'd better
00:41:14.440
know how to react. So becoming a market historian and attending to those base rates is extremely
00:41:19.820
important. So maybe like you tape it up, tape up like a chart of the base rates, like next to your
00:41:24.780
computer. So if you make a decision, like you look at that first. Yeah. Well, you know, I think there's
00:41:29.400
just a couple of things to know. Like, I mean, the markets, the market tends to be up. The market
00:41:34.360
tends to be up about two days for every one day that it's down. So, you know, if you have a down day
00:41:40.580
or even a down year, it's not that rare. I mean, it happens about a third of the time.
00:41:45.080
That's no excuse for you to get off course. You know, the average, uh, bear markets about a year
00:41:50.260
and a half to two years long, and it has about a 37% loss of, you know, destruction of capital.
00:41:56.740
But I promise you that the next time that the market drops 30%, people are going to think that
00:42:02.480
it's going to zero, right? So they, we don't understand the base rates. We don't understand the
00:42:08.120
history. We don't understand what normal is. And because we don't understand what normal is,
00:42:13.420
everything seems scary to us. So I love your idea of just having a note card with a couple of those
00:42:19.120
basics and keeping it, keeping it right there. Well, another, you just mentioned something that
00:42:23.420
I thought would be useful too, is like, don't check your portfolio every day because you're going to
00:42:27.640
see this go, it's going to go up and it's going to go down. It's going to go down more and it's going
00:42:31.340
to go up like maybe once a month, maybe like once a quarter. Yeah. So, so what's interesting is the,
00:42:37.260
the longer you can go between checking it, the more likely you are to be up, right? I mean,
00:42:42.300
because if you look at, you know, if you look at any given day, the market's up about 60% of the
00:42:47.320
time and down 40% of the time. You look at any given year, it's about 66, 33. You look at any 10 year
00:42:54.300
period, I think there has only been one rolling 10 year period in, in US history where the market was
00:43:00.340
down. So, you know, the, the longer you can go between looking, the better off you'll be.
00:43:06.460
And one of the things that is actually very much to the detriment of everyday investors is the ease
00:43:12.560
with which we can check our accounts. Now, you know, back even 20 years ago, you had to wait on
00:43:18.080
a quarterly statement. Now you can check your, you know, you can check your account 15 times a day.
00:43:24.140
And I know many people do. And the tricky thing is one of the findings of behavioral finance,
00:43:30.320
this is what Daniel Kahneman won his Nobel prize for is that a loss hurts two and a half times as
00:43:36.860
much as a gain feels good. And so if the market's down 40% of the time daily, and it hurts two and a
00:43:45.280
half times as much as the 60% feels good, it feels like it's down 90% of the time. So in a,
00:43:51.980
in a very real sense, if you're checking it daily, it's going to feel like you're always losing money,
00:43:57.480
even though that's not the case. All right. So don't check your portfolio every day or 15 times
00:44:02.020
a day. So emotions, we talked about emotions a little bit at the beginning, like being angry,
00:44:06.040
being hungry, being hangry, thirsty, happy, sad, like that can all influence our decision.
00:44:12.340
But the weird thing with emotions though, it's like we, there's been studies that showed you talk
00:44:16.200
about this in the book that like we actually need emotions to make decisions. So how can you,
00:44:21.980
how can you make decisions while mitigating the downsides of emotions? Cause you need them,
00:44:27.480
right? Yeah. You know, the book is some interesting research. I cite in the book that you brought up
00:44:33.780
talks about how people who had the emotional processing centers of their brain damaged,
00:44:39.120
they couldn't do, they couldn't decide which flavor of ice cream they wanted. They couldn't,
00:44:44.260
you know, figure out which color suit they wanted to wear that day. They couldn't make even
00:44:49.040
very sort of garden variety decisions because what the researchers found is that, you know,
00:44:54.440
even the simplest decision has an emotional substrate, even the most common decision you
00:44:59.620
make has an emotional underpinning to it. That's important and guides our decisions.
00:45:03.940
So there's no getting away from emotion entirely, but what's fascinating is they found that these people
00:45:10.960
who couldn't pick out, you know, their favorite flavor of ice cream were actually great gamblers and
00:45:16.240
great investors because they approached investing and gambling from a strictly mathematical place.
00:45:23.420
There was no emotion involved in their day-to-day decisions, but there was likewise none involved in
00:45:28.120
their, in their investing decisions. And they, they beat people with normal brain function.
00:45:33.200
So people with brain damage were better than, than you or I at making financial decisions.
00:45:38.700
And so the, the key to me is avoiding emotional extremes, you know, so there's a, there's an
00:45:44.660
acronym that I've stolen from the, the 12 step program called HALT. And it stands for hungry,
00:45:51.180
angry, lonely, or tired. And, you know, the, the advice of people in AA or narcotics anonymous,
00:45:57.200
or, you know, any of those 12 step groups is to avoid making an important life decision when you
00:46:02.700
were hungry, angry, lonely, or tired, and, you know, fill in your emotion of choice. And, you know,
00:46:08.640
I would say the same thing about investments. If you're, you know, if you're fearful, if you're
00:46:13.400
greedy, if you're excited, like all of these are bad places to be like good investing is enormously
00:46:19.320
boring. And so if you find yourself in one of these elevated mood states, it's not a good place to be
00:46:27.220
So it sounds like, so we've talked about all the, the, the sociological, the physiological,
00:46:31.760
the psychological things get in the way of us making good decisions. And we've talked about some
00:46:35.900
solutions and the solutions, like they're very simple. Like this framework you've established,
00:46:40.060
it's basic and it's stuff that we know, but it now it's backed by science is diversify, automate,
00:46:45.900
don't check on it too frequently and don't make decisions when you're emotional.
00:46:50.800
Yeah. It's that, that's, what's fascinating about this is, you know, you write a 300 page book,
00:46:55.720
you read a zillion articles, and then at the end you go, okay, here's what you do. You automate
00:47:00.660
because simple rules be human discretion. 94% of the time, you know, you get an advisor because,
00:47:08.020
you know, there's about 10% of the world I think that can is, is so disciplined that they can do
00:47:13.180
these things on their own. And those people do exist, but most people need someone to hold their
00:47:19.180
hand and keep them from making a handful of dumb decisions. You know, you manage your fees, you,
00:47:24.160
you try not to be overactive and you have low turnover, you diversify.
00:47:28.580
So yeah, the, in, in some ways the suggestions are remarkably unsexy, but again, the degree to
00:47:35.380
which all of this is complicated in a weird way necessitates a simple approach.
00:47:40.900
Well, you mentioned advisors and you and I actually had a phone conversation a couple of
00:47:43.520
weeks ago about this. And I asked you like, who's the type of person who should get an advisor?
00:47:47.260
And you said like, it's, it's someone who probably needs help with like the behavioral aspect. It's not
00:47:52.020
so much like what to invest in, like, you know, having someone tell them what to like,
00:47:55.340
what to actually invest in, but they might do that. But it's more like you need an advisor to
00:47:59.660
make sure you stick to the plan and you do the thing you're supposed to do.
00:48:03.980
Yeah. So, you know, in the laws of wealth, chapter, chapter two of the laws of wealth was,
00:48:08.900
you know, it was titled, you need a financial advisor, but not for the reason that you think.
00:48:13.640
And so in that chapter, I make the case that the best, the highest and best use of a financial
00:48:18.380
advisor is to effectively save you from yourself. And the research shows that people who work with an
00:48:24.420
advisor on average do two to 3% better per year than those who do not. And that is a ton of money.
00:48:30.600
I mean, so, you know, 3% a year will double your, you know, double your wealth over, over a long
00:48:35.660
investment horizon. And so it's, it's tricky though, because, you know, candidly some, some automated
00:48:42.560
service like Betterment or, you know, another robo-advisor would give you in many cases, the very
00:48:47.880
same suggestions as a financial advisor at a, at a fraction of the cost. But, you know, the question
00:48:55.340
you have to be really brutally honest with yourself about is, is, is an automated service, you know,
00:49:02.400
is reading a book on asset allocation going to keep me in my seat when the, you know, and when the
00:49:08.220
market is ripping my face off. And, and for most people, candidly, the answer is no, you know,
00:49:13.820
there's, there's a really, really weak correlation between knowing the right thing to do and actually
00:49:20.220
doing it. You know, I, I love to give the example of, of nutrition labels on food. You know, we started
00:49:27.300
labeling all of our food about 28 years ago. And since that time, since this time when we've had
00:49:35.220
perfect knowledge of calories and fat and sodium and sugar and, you know, every other thing on
00:49:39.860
everything we put in our bodies, obesity is doubled, morbid obesity is tripled because knowledge is just
00:49:46.580
a weak predictor of behavior. And so even if you know just how to invest, even if you have a sound
00:49:52.340
asset allocation, your ability to stick with that allocation is far more predictive of whether or not
00:49:58.580
you reach your goals than, than you knowing what a good allocation is. That reminds me, I don't know
00:50:03.700
if this is going to going off in the deep end, but so I've been rereading Oedipus Rex, the, the Greek
00:50:08.840
tragedy. And I thought it was interesting. Oedipus, like he knew that he was going to kill his father
00:50:15.900
and marry his mother. Like he knew that that's why he left his hometown, but he still did it anyways,
00:50:21.600
because like he just got angry and like he killed the guy, an older guy. He shouldn't have been
00:50:26.400
killing anybody. So like he did. It's like, that's a great example of like, man, this stuff's been around
00:50:30.280
for long. You can still, you can know this stuff, but you can still screw it up.
00:50:33.840
Yeah. Yeah. You know, I, I saw something the other day on marital infidelity. It's something
00:50:39.500
like four, 40% of people cheat on their partners. And, you know, if you ask those people, you know,
00:50:45.480
Hey, was that, was that consistent with your values? You know, was that the thing you wanted
00:50:50.320
to do? They would all tell, you know, I mean, you know, or nearly all of them. And so it's,
00:50:56.080
it's just incredible how little education does. I mean, it's actually, it's actually quite depressing
00:51:01.560
when you, when you start looking into financial literacy initiatives as, you know, as a guy who
00:51:06.360
writes books that try and educate people on how to, how to manage their money and what to do with
00:51:12.020
their wealth. It's depressing. So really, I think education is necessary, but not sufficient. And
00:51:17.820
that, you know, the next thing you need to do is put in place structures, be they automated or be they
00:51:24.080
an advisor that are going to help keep you on the course. Education tells you which course to go on,
00:51:29.860
but you need some sort of commitment device that keeps you on that course. And that's going to be
00:51:35.060
a much better predictor. You want to be like Odysseus and tie yourself to the mast, tie yourself to
00:51:40.080
the mast, fill your ears with beeswax, just like Odysseus. There we go. We got, I like how we got
00:51:44.800
Greek here a little bit. Well, Daniel, where can people go to learn more about your work?
00:51:49.420
So a couple of places, I have my own podcast called Standard Deviations. I'm active on Twitter
00:51:54.660
at Daniel Crosby on LinkedIn a lot, Daniel Crosby, PhD, and you can find the books on Amazon.
00:52:01.000
Well, Daniel Crosby, thanks for your time. It's been a pleasure.
00:52:03.800
My guest today was Daniel Crosby. He's the author of the book, The Behavioral Investor. It's available
00:52:07.460
on amazon.com. Also check out our show notes at aom.is slash behavioral investor, where you can find
00:52:12.520
links to resources, where you can delve deeper into this topic.
00:52:14.940
Well, that wraps up another edition of the AOM podcast. Check out our website,
00:52:25.640
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00:52:29.600
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