Behavioral finance isn’t something new. They’ve given out a Nobel Prize on the topic. But actually putting into practice some of the insights from the field is a different thing altogether. Understanding human behavior and the complexities involved is one of the main thrusts of Daniel Crosby’s new book.
In The Behavioral Investor, Daniel Crosby (@danielcrosby) not only helps understand the basis for our actions but how to live our investing lives with these biases in mind. Daniel is the Chief Behavioral Officer at Brinker Capital. He previously authored The Laws of Wealth. You can also hear more from Daniel on his podcast Standard Deviations.
I had to the pleasure to ask Daniel some questions about his new book. Below you can find my questions in bold. Daniel’s (unedited) answers follow. Enjoy!
AR: Why another book? What have you learned since “The Laws of Wealth” that compelled you to write another book?
DC: I have long been of the mind that behavioral finance was lacking a “so what?” We’ve known for a long time that investors aren’t perfectly rational and that they act in self-sabotaging ways, but we’ve done much less, practically-speaking, to see that those wrongs get righted. A first step in that process is agreeing on a universe of misbehavior because it’s only know how we keep making mistakes that we know what to do about it. In The Laws of Wealth, I introduced this universe at a high level, distilling down the 200 or so individual errors into just a handful, but I didn’t have time to cover them in any depth. In The Behavioral Investor, I look at not only the universe of psychological mistakes but also the neurological and sociological impacts on our investment thinking. I say in the preface that my (audacious and perhaps impossible) goal was to make it the most comprehensive look at the person of the investor ever written and I’m pleased with how it came out.
AR: One upside I see from the FIRE movement is a greater focus on the idea of “How much is enough?” This clearly depends on the person, but how much is enough?
DC: The FIRE movement has come under, um, fire for reasons that I don’t fully understand and I think it speaks to how fully bought in the average American is to the “more is better, work forever” mindset. It’s important to understand that we are not wired to ever think we have enough. As I discuss in the book, our perpetual discontent, as painful as it may be for our psyches, is a big part of what has pushed us forward in the face of uncertainty. Since the ability to store wealth with relatively little space and danger is fairly recent, we as a species are not set up for contentment. It’s been evolutionarily adaptive and for that reason, it’s hard to extinguish, even when an individual has amassed great wealth. Understanding that we are prone to moving the goalposts, it becomes important to write down what “enough” looks like, to eschew lifestyle creep at every turn and to focus on what matters most to you outside of wealth creation. Money does an excellent job of buying the absence of misery but does very little to buy happiness.
AR: I loved this line: “Like a flower growing through the pavement your brain is beautiful but out of place.” What do you mean by this and how should affect how we think about investing?
DC: I walked away from The Behavioral Investor with an increased measure of awe about our minds and bodies in general and an absolute understanding that they are ill-suited to investing in particular. For instance, our tendency to look for patterns preserved us in the wilderness, allows us to learn from past relational mistakes and even leads us to advances in hard sciences that have positively impacted the lives of millions. But when you try and take that propensity to look for patterns and overlay it on capital markets, you see folks trying to analogize today with 1929 and laying charts on top of each other to look for the next 1987. In the end, it’s all about context and what works marvelously well in many scenarios won’t work well at all in others.
AR: You mention a couple of times in the book both the R.A.I.N. method and meditation. One of the big benefits of this practice is to recognize your emotions when they are happening. What else can mindfulness do for us as people and investors?
DC: Human beings are unique among the animals in the sense that they can cast their minds backward, forward and remain in the present moment. That has huge utility, like being able to strategize for the future, but it’s also the source of most our distraction, anxiety and depression. Mindfulness is simply a method for grounding yourself in the moment and enjoying a heightened sense of awareness about right now. Spending time in the past and future is seldom where we are at most rational. We are either pining for a bygone moment or “catastrophizing” the days to come, neither of which are in our power. Mindfulness grounds us in the only timeline in which we have any power: right now.
AR: The most ignored phrase in investing is “I don’t know.” What is about uncertainty and ambiguity that drive us search unceasingly for answers to questions that likely don’t have answers?
DC: At the risk of being excessively philosophical, I think owning randomness to the degree that it’s present in both life and markets is terrifying precisely because it speaks to how arbitrary life really is. We want to believe in justice, fairness and the triumph of the smart and good over randomness but that’s now how the world works. So, it’s both honest and existentially terrifying to admit to ourselves that sometimes stuff just happens. This is so pronounced that research even suggests that we’d prefer a bad known to an ambiguous unknown which is why you see people returning to bad but familiar relationships, patterns of substance abuse and the like.
One of my favorite Kierkegaard quotes is “anxiety is the dizziness of freedom” and I believe that most investors are dizzied by the range of possibilities present in the markets at any given moment. Instead of owning that literally anything could happen and they have no idea what, it’s easier to try and ground ourselves in tuning in to forecasts, staunchly allying ourselves with a school of investment thought or investing alongside our politics, all of which are disastrous ways to operate. But in the face of all of this uncertainty, it’s worth remembering that our behavior remains within our power and our tendency to make a few simple choices like manage risk, maintain a long-term perspective, manage fees and dollar cost average all bode well for us over time. The process remains very much in our control even when the outcomes do not.
AR: My colleague Barry Ritholtz recently wrote, “In the old days, we invested by Narrative and marketed by Data. The new order has reversed that order, with quantitative analytics driven portfolio creation and narrative story-telling selling them.” It sounds like you would agree with his take…
DC:I think that has comments are true among the best and brightest in the investment world and I do see the world changing, but there will be investing by story as long as there are stories to be told. In the book I cite interesting research out of Princeton that shows what happens to the brains of two people when they are talking. If they are talking in technical terms, comparing facts and figures, their brain patters are dissimilar. But the moment one person begins telling another a story, their brains light up in near lockstep, almost as if the brain of the person telling the story was picked up and dropped inside of the head of the person listening. Selling via stories is incredibly effective and is as good or as bad as what is being sold. Investing via stories gives an illusion of certainty and cohesiveness where none is likely to exist.
AR: One of the most important ideas that it took me awhile to learn, thanks 100% to Michael Mauboussin, is the relative importance of luck vs. skill not only in business and investing but in life in general. How do you think about luck vs. skill in the context of investing?
DC: I think that skill, insofar as it exists (and I believe that it does), has a great deal more to do with managing bias, making difficult decisions and slavishly following widely accepted rules than having some other sort of edge. Ultimately, there are tens of thousands of funds and billions of investors that are all looking at the same basic market metrics, meaning what separate those who outperform from those who underperform has very little to do with your information and a great deal more to do with your ability to act dispassionately on that information. Information is increasingly a commodity, acting in a disciplined manner on that information will forever be in short supply.
AR: One of the downsides of the rise in behavioral finance is the common belief that OTHER people have biases, but we do not, i.e. bias blindness. You take a whack at this by advocating for the “acceptance of personal mediocrity.” I am getting it right?
DC: You did get this right, but no righter than anyone else would have 🙂
The very first thing a true behavioral investor must do is realize that s/he is just as susceptible to all of the same risks, oversights and foibles as the next person. We tend to own the optimistic (“I have good odds of winning the lottery”) and delegate the dangerous (“I won’t get divorced”) but behavioral investors consider base rates and act accordingly. The best we can hope for in markets is to tilt the odds in our favor repeatedly, understanding that we’ll likely win just slightly more hands than we lose, but that this edge can make a dramatic difference over time. My first book and TEDx talk was called, “You’re Not That Great” and it’s a powerful message for those who can truly internalize it.
AR: In the light of the fact that our brains are, at best, imperfect tools to go about the business of investing. If that is the case, where does the financial advisor come into play? It seems that we investors can use all the help we can get…
DC: I, along with many others in the industry, now believe the primary benefit of financial advice to be behavioral. The tricky thing about good financial decision-making is that education is a fairly weak predictor of behavior. There are all sorts of educational resources available to the retail investor today – blogs, white papers, all the way to robo-advisors that will automatically create a near perfect asset mix – but none of these things can prevent the panicked investor from being their own worst enemy. I liken it to nutritional information which is widely available and widely ignored. In fact, some research suggests that restaurants that list calorie counts on the menu actually lead diners to eat slightly *more* than those that don’t list them. Investors do not need an advisor to tell them how to invest; a long weekend of reading the right books would point the average investor in a good direction that could be implemented simply and cheaply. However, that very same investor is highly unlikely to stick with that plan through thick and thin, which is the only thing that matters in the long-term.
In Chapter 2 of The Laws of Wealth, I cite a handful of studies showing that those who work with financial advisors tend to dramatically outperform those who don’t and argue that the reasons for that outperformance owe almost exclusively to behavioral coaching. Interestingly, the research also suggests that while investment advisors help their clients dramatically, their personal portfolios are subject to some of the very same mistakes they counsel their clients against! The reality of human nature seems to be that education doesn’t mean nearly as much as having someone on our side to slap the donut or the trade out of our hands at the moment of maximum weakness.
Thanks again to Daniel for his time and insight. You can follow him on Twitter @danielcrosby.