Long read: Humans Are Not Built For Investing

Yet another brilliant piece from the Ritholtz stable. Along with the blogs, Barry’s podcasts with its incredible line up of guests provide invaluable insights on personal finance among other things. This one is on behavioural aspects of investing with Dr. Daniel Crosby, who 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.”

The podcast begins with Barry asking Dr Crosby about why a rules-based approach to managing is important and how otherwise we tend to get distracted by things beyond our control:

“Rules match or beat expert level decision making 94 percent of the time, which is pretty staggering. And we see this across contexts…from medical diagnosis to stock picking to financial planning, to prison recidivism studies. That one’s one of my favorite. They went from having these soul searching interviews with prisoners to looking at two variables, – 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%.

So a rules based approach works is one reason and they’re cheap is another reason. …it’s a lot cheaper to set up a checklist or a simple set of rules than to pay a bunch of CFAs,….

…I love the idea of the checklist because it plays very much into an issue. There’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.

…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 outside of their power….we have to encourage people to take the power back – 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”

And then Barry moves the discussion to our biases, especially our overconfidence bias and how terrible we are at predicting the future:

“…there’s three specific ways that we’re overconfident. …the first is we think we’re better than average, right? Smarter, better, faster, stronger, better at picking stocks…then we think we’re luckier than average. So you ask people what’s the likelihood of something happening to you, like getting divorced and 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 have diabetes or on and on. But if you ask people about their odds of finding love or winning the lottery, they, they dramatically overrate these probabilities. So we sort of tend to own the optimistic and delegate the dangerous.

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.”

Barry then invokes the legendary Nobel prize winner Daniel Kahneman who showed the mirror to us humans about our biases and had once said when asked what can we do to avoid behavioral biases “…nothing. We can’t avoid it. They’re just totally unavoidable.” “Hey, if Danny Kahneman can’t avoid them, what hope did the rest of us have?”

He refers to the section in Dr Crosby’s book that talks about how our need for action (like in day trading or watching financial news or making predictions) is because of the way we are wired: “Our brains are 2-3 percent of our body weight, but they’re 20 to 25 percent of our caloric expenditures in a given day. And so when we look at people hooked up to an MRI 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, right? We’re looking for that peace of mind. We’re looking to think less and go into energy saver mode. So as bad as we are at forecasting, there will always be a market for some sort of certainty.”

So what we can we do?

“I think the two best hopes we have against behavioral bias is automation [rules based investing] and working with a professional.  The data is very clear now that people who work with a professional tend to do better than those that don’t.”

And what’s the role of the advisor?

Referring to a 2016 Merill 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…Everything from security selection to asset allocation to tax alpha, it all helps. But the thing that helps the most is behavioral coaching, the emotion management, the guidance around decision making keeping you from investing in your son in law’s dumb business, these pivotal points along the way…. that’s really where it adds about as four times as much value as the other stuff. And 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 non financial 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 rise as well.”

Barry sums it 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.”

If you want to read our other published material, please visit https://marcellus.in/blog/

Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.