At The Money: Humans Are Not Built For Investing (August 7, 2024)
Of all the many things Humans do brilliantly well, investing isn’t one of them. As a group, we are easily excited, focused on the wrong things, and filled with unjustified overconfidence.
Full transcript below.
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About this week’s guest:
Dr. Daniel Crosby sits is Chief Behavioral Officer at Orion Advisor Solutions, where he helps financial advisors apply behavioral science in their practice. He is the author of “The Laws of Wealth: Psychology and the Secret to Investing Success.”
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Daniel Crosby Transcript
Barry Ritholtz: Humans are a species of incredible innovation — in Art, Science, Literature. Yet of all the things we’re brilliant at investing isn’t one of them. Why? Well, we’re easily excited. We get focused on the wrong things, obsessed with what just happened rather than what might happen next. We’re bad at understanding maths, and we despise delaying gratification. Top all of this off with unjustified overconfidence, and you have a recipe for investing under-performance.
As it turns out, when it comes to investing, we’re just not built for it.
I’m Barry Ritholtz. And on today’s edition of at the money, we’re going to discuss how to become more systematic and rules based in managing our money to help us unpack all of this and what it means for your portfolio.
Let’s bring in Dr. Daniel Crosby. He’s the chief behavioral officer at Orion, where he develops tools, training, and technology, to help financial advisors apply behavioral science in their practice. He is also the author of the book, “The Laws of Wealth, Psychology and the Secret to Investing Success.”
So Daniel, let’s start with just a basic idea. Why is a rules-based approach to managing money so important?
Dr. Daniel Crosby: One reason is because rules work, you know, when we look at a meta-analysis, so this is a study of all the studies on how rules fair, simple rules, fair against a PhD level discretionary decision making, right?
Rules match or beat expert-level decision-making 94% of the time, which is pretty staggering. And we see this across contexts. We see this everywhere from medical diagnosis to stock picking to financial planning to prison recidivism studies. That one’s one of my favorite — they went from sort of having these soul-searching interviews with prisoners to looking at two variables, you know, what are they in for? And how did they act while they were in — and they increased the efficacy of their judgments by almost 400%.
They work is one reason and they’re cheap is another reason. It’s, it’s a lot cheaper to set up a checklist or a simple set of rules than to pay a bunch of CFAs to try and get it right. So they work and they work on a budget.
Barry Ritholtz: I love the idea of the checklist because it plays very much into an issue that’s a pet peeve of mine, which is investors tend to obsess about all these things they cannot control things that are out of their jurisdiction while ignoring the things that they can control. Talk a little bit about how creating a checklist allows you to focus on things that are within your control.
Daniel Crosby: When I wrote the book, you know, the very, the very first chapter, and I was intentional about the ordering. The very first chapter in the book is you control what matters most. Because I found what I think you find when you tell someone you work in markets that you work in finance, they ask you about a hundred things. All 100 are outside of their power: “What’s the Fed going to do? What’s the virus going to do? What’s the war going to do? Who’s going to win the election? Stuff that is almost inevitably unknowable and be outside of their power.
So what I think we have to encourage people to do is to take the power back — and to frame it that way because things like fees, things like diversification, choosing to work with a professional, all of these things are within our control and are far more predictive of you crossing your financial finish line than any of that other stuff.
Barry Ritholtz: There’s a great story in Michael Lewis’s book, um, about Sam FTX about Jane Street Trading. And even though they got the 2016 election results correct, they still were unable to anticipate what the market reaction would be. So not only are these things out of your control, and, and they are unknowable, but even when you know it, Hey, what’s the reaction of tens of millions of traders going to be? We really have no idea.
Daniel Crosby: It’s true. Like no one thought Trump would win. And then most folks who thought that he would win, thought that it would tank the market, uh, both things were proven wrong,
Barry Ritholtz: Really, really amazing. So, so let’s bring this back to the investing decision-making process. You emphasize why the process of making good decisions is so much more important than trying to predict market movements, explain.
Daniel Crosby: It’s really about being the house and not the degenerate gambler, right? If you look at all the bright lights in Vegas, all that gets paid for by tilting probability in favor of the house. And if you look at a lot of casino games, the edge the house has is not dramatic. I mean, in some cases it’s infinitesimally small, but tilting probability in your favor time and time and time again, showing up doing the things that are within your power time and time again, pays for some nice lights and some nice fountains as we see in Vegas. That’s all we’re trying to do here. Control the controllable tilt probability in our favor in a small way. You’re not always going to get it right, but you’re always going to be at the wheel.
Barry Ritholtz: I mentioned in the introduction that we’re all filled with so much overconfidence. You have a chapter titled, “You are not special.” Tell us about why investors need to stay humble and why we’re all subject to the same biases and errors as everybody else…
Daniel Crosby: I love this one because I think it demonstrates how psychological biases can serve us, uh, they, they serve us well in some domains in life. If we look at overconfidence bias, it serves us really nicely in some ways. People who exhibit it are happier. They’re more successful. They’re more likely to be successful entrepreneurs. God, they’re, they’re definitely more likely to run for office. There’s all of these things that that overconfidence does.
But when you apply it to markets, there’s, there’s three specific ways that we’re overconfident. The first is we think we’re better than average. Smarter, better, faster, stronger, better at picking stocks.
That’s the one that gets the most publicity, but there’s actually two others as well. One is we think we’re luckier than average. So you ask people, you know, what’s the likelihood of something happening to you, like getting divorced and like effectively no one says they’ll get divorced, even though, you know, one in two people gets divorced. No one thinks they’re going to get cancer or, you know, have diabetes or, you know, on and on and on. But if you ask people about their odds of finding love or winning the lottery, they, they dramatically overrate these probabilities. We sort of tend to own the optimistic and delegate the dangerous.
That’s a second sort of facet of overconfidence. And then the third one is we think that we’re more prescient about the future than we actually are. Like we think we’re better at forecasting what’s going to happen. So these three forms of overconfidence are a pretty toxic cocktail of bad decision making.
Our mutual friend, Jim O’Shaughnessy has this great line in his, his seminal work, “What Works on Wall Street” that I’ll butcher here, but it’s effectively like, look, rule one, step one. Is understanding that you are prone to all of the same screw ups as the next person. And until you’ve sort of deeply internalized that you, you shouldn’t start.
Barry Ritholtz: Jason Zweig asked Danny Kahneman what he does to avoid. all of the behavioral biases and heuristics that him and Amos Tversky discovered. And his answer was nothing. We can’t avoid it. They’re, they’re just totally unavoidable. Hey, if Danny Kahneman can’t avoid them, you know, what hope did the rest of us have?
There’s another, uh, line I really appreciate and, and this perhaps is because I began on a trading desk and what led me to realize it was time to move on was how much fun I was having regardless of my P& L. You write, “If it’s fun, you’re probably not making money.” I bet a lot of traders can confirm this. Tell us why fun and making money are not necessarily consistent and what we need to do to be more methodical and more disciplined.
Daniel Crosby: It’s really like one of these harsh truths about, I refer to it in the, in the book as Wall Street bizarro world, how the truths of every day are sort of one 80 to the truths of, of markets. And one of the things that we find is some of the most exciting, most fun ways to, to try and make money in the markets are the most deleterious to our wealth.
You look at day trading, the most comprehensive study on day trading ever done. was out of Taiwan, and they found that 1-in-360 day traders show evidence of skill. Is day trading fun? Like, absolutely. It’s a blast, right? Like making short-term trades can be fun. It can be intoxicating. It can be exciting. But the, the chances of you being good at it are vanishingly small.
You look at other stuff like IPO investing, you know, everyone’s got this story about if you’d put 10, 000 in Nvidia or Apple or whatever, you’d be a gazillionaire now. But we know that on average IPO does 21% worse than the S&P 500 in the first three years. And so again, is, is IPO investing fun? Yeah, absolutely. But you are the gambler. You are the gambler and not the house. And you’re unlikely to secure that Monet if you’re, if you’re engaging in these sorts of fun behaviors.
Barry Ritholtz: Let’s talk about forecasting is for weathermen. Why are we so bad at forecasting and what should we focus on?
Daniel Crosby: Well, it goes back to that. You know, it’s one of those primary forms of overconfidence and the research on this is just wild. You know, Philip Tetlock did sort of the seminal research on political and financial forecasting and found that even the experts are terrible at this. And in fact, the more famous an expert, the worse they tended to be. Because the way you get famous as a market prognosticator is making sort of a once in a lifetime black swan prediction. And then you tend to continue to bang that drum because it worked the first time and you know, history on average is pretty average and then you’re wrong.
But the reason we’re always going to look for this is the way that we’re wired, right? Our brains are 2 to 3% of our body weight, but they’re 20 to 25% of our caloric expenditures in a given day. And so when we look at people again, hooked up to an FMRI machine who are watching cable financial news, watching someone make predictions about what’s going to happen, the part of their brain associated with critical thinking and decision making actually goes to sleep which is candidly what we are looking for.
We’re looking for that peace of mind. We’re looking to think less and go into energy-saving mode. So as bad as we are at forecasting, there will always be a market for some sort of certainty. And I think the only thing that we can do is to work with a financial advisor who can give us some sort of certainty around our plan, our purpose, our immediate financial lives, instead of delegating that to some impersonal talking head.
Barry Ritholtz: So I’m glad you brought up the financial advisor. You discuss. how hard it is to do this alone and why you should seek professional advice and support, if for no other reason than to help you manage your biases and your emotions, discuss your experience with people working with professionals.
Daniel Crosby: This is, this is one of probably the two most powerful things you can do to manage those behavioral biases that Danny Kahneman talked about. He talks, as you said, about the futility of it. I think the two best hopes we have against behavioral bias is automation, and working with a professional.
The data is very clear now that people who work at the professional tend to do better than those that don’t. And when we look at a 2016 Merrill Lynch study. The things that an advisor does for you are all additive. They broke this down by the different things that an advisor does in his or her day. Everything from security selection to asset allocation to tax alpha, it all helps. But the thing that helps the most is again, this behavioral coaching, the emotion management, the guidance around decision-making keeping you from investing in your son-in-law’s dumb business, just these pivotal points along the way. That’s really where it adds about as 4 times as much value as the other stuff.
What’s cool for me as the son of a financial advisor who works with financial advisors every day is people who work with an advisor have better marital communications. They have higher levels of aggregate happiness.
They’re more prepared for an emergency. Like they have all these nonfinancial things in their life that get lifted because money touches everything we do. So if you can get that right, a lot of other boats in your life start to start to rise as well.
Barry Ritholtz: So to wrap up, humans are great at a lot of things. But we also come prepackaged with a lot of evolutionary baggage. We’re easily excitable. We make poor decisions. We think we’re special. We’re wildly over-optimistic, and we tend to overreact to every sign of trouble like it’s the end of the world.
We’re much better off if we have a rules-based systematic approach to managing risk and investing for the future rather than making these decisions on the fly. To help your portfolio, you really need to think about what is the best result for you over the long haul, not just making these decisions spur the moment.
I’m Barry Ritholtz. You’re listening to Bloomberg’s At The Money.
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