With Daniel Crosby, President at Nocturne Capital, Best-selling Author of The Behavioral Investor and respected financial thinker
Podcast: Play in new window | Download
Steve’s guest, Daniel Crosby, is a best-selling author. His latest book, The Behavioral Investor, looks at psychology’s role in the art and science of investment management. Daniel was named one of the “12 Thinkers to Watch” by Monster.com, and a “Financial Blogger You Should Be Reading” by AARP.
Evolution Makes Us Weak Investors
Going back thousands of years, we weren’t the only human species on earth. There was a group called the Hobbits in Indonesia, the Neanderthals in Europe, and the Denisovans in Asia. Scientists believe that the reason we, the homo sapiens, outlasted the other groups of humans was that we were more fearful and relatively unwilling to take risks.
While this loss aversion has been a great boon for us as a species, it makes us poor investors. As Steve notes, the pain of loss is at least twice as intense as the pleasure of an equal gain.
Fear Leads To Poor Decisions
In The Behavioral Investor, Daniel Crosby notes that when people are under financial duress, their cognitive processing power drops significantly. Consequently, we lose willpower and get emotional, just when we should not.
This was borne out by a study of judges over a ten-month period. It found that you had a 65% chance of getting paroled in the early morning hours at court, shortly after the judge’s breakfast. If you were the last person seen right before lunch, you had a next-to-zero chance of being paroled because the judges were hungry and felt like punishing someone for it.
After lunch, parole rates jumped back up to about 65%, then gradually declined through the afternoon. While hunger reduces our objectivity, fear makes it much worse.
This is why Daniel is a big advocate for automating investment decisions by outsourcing them to financial professionals.
Defying The Law Of Averages
Another study showed that 94% of a surveyed sample of men rated themselves above average on measures such as friendliness, sense of humor, and looks. This over-confidence leads us to start businesses and do all manner of things that are good for society.
But it also causes us to fail in our investment decisions.
To Succeed At Investing, Do Nothing
Daniel Crosby cites the following example in his book, The Behavioral Investor. If you want to get stronger, you should spend more time at the gym. If you want to become smarter, you should read more books. But if you want to make more money, you’re actually better off doing nothing.
A study across 19 countries found that the more people traded, the more they watched financial news, the worse they did.
This doesn’t surprise Steve. Many of his newer clients want him to anticipate economic and stock movements and trade more actively. But Steve knows the futility of excessive trading and plans to do less because it’s better for his clients’ portfolios.
Financial Advisors Add 3% To Your Performance Every Year
In his previous book, The Laws of Wealth: Psychology and the secret to investing success, Daniel Crosby showed that people who work with a financial adviser do about 3% better per year than those who don’t. Compound that over 15+ years, and people with financial advisors end up with more than 2.5 times the wealth of those without.
The difference lies in three to four catastrophically stupid decisions over a lifetime. While it’s hard to tell someone you can make them three-times richer by helping them do nothing, research shows this to be absolutely true.
Disagreeing With Peter Lynch
Peter Lynch, the highly successful manager of Fidelity’s Magellan Fund advocated buying shares of companies whose products you loved. But Daniel disagrees.
First—because that is something most investors are predisposed to doing. For instance, investors in the Midwest tend to be overweight agriculture, and those in the Northeast tend to be overweight financials. People confuse what they know with what is good and lose sight of portfolio diversification.
Second—people’s holdings of certain stocks distort their objectivity and make them unable to see the shortcomings of the stocks they hold. For instance, Apple’s shareholders can’t objectively assess Apple’s shortcomings. This is called status quo bias.
Agreeing With Warren Buffett
Lynch’s advice differs from Warren Buffet’s idea of investing within your circle of competence. Buffett urges investors to stay away from things they do not understand, such as technology or cryptocurrency. And that’s good advice for the average investor.
Buffett would never have you load up on Coca-Cola stock if you worked at the company because that’s your bread and butter. Buffett’s circle of competence idea is a check on your ego. Whereas, Lynch’s idea may lead us to confuse what we know with what is safe.
Invoking Rudyard Kipling
Daniel’s views on the value of patience remind Steve of “If”-, Rudyard Kipling’s famous poem.
If you can keep your head when all about you…
Yours is the Earth and everything that’s in it,
And—which is more—you’ll be a Man, my son!
Slowing down or sleeping on a decision is useful because it lessens the degree to which we fall prey to status quo bias by about 32%.
Under pressure, people tend to do what’s easy or comfortable, which may or may not be the right thing. Slowing down helps us be more deliberative and make better decisions.
Along the same lines, research finds that bilingual people make better decisions when they think in their non-preferred language. So if a native English speaker learns Spanish, mulling over major decisions in Spanish would make them more deliberative and less emotional.
Similarly, sleeping on investment decisions and talking to a trusted advisor is always a good idea.
Thinking About It In Spanish Is A Good Idea
In closing, Daniel says investors should also not fall prey to seductive stories. If a compelling speaker narrates a story, the listener often gets entranced, loses objectivity, and ends up following the story’s lead, Pied Piper-like.
So the next time you hear a great stock story or investment thesis, don’t jump into action. Instead, heed Daniel Crosby’s advice in The Behavioral Investor —sleep on the idea, then discuss it with your financial advisor before making your move.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: With me today is the New York Times best-selling author of the book named The Best Investment Book of 2017. Author Daniel Crosby joins me to discuss his newest book, The Behavioral Investor, which is an applied look at how psychology ought to inform the art and science of investment management. Daniel was named one of the 12 Thinkers to Watch by monster.com and as a financial blogger you should be reading, so says AARP. Welcome to the show, Daniel.
Daniel Crosby: It’s great to be here, thanks for having me.
Steve Pomeranz: What makes us strong as human beings makes us weak money and financial managers for ourselves, why do you say that?
Daniel Crosby: Well, that’s a big part of the first part of the book talks about things that have served us well evolutionarily make us poor investors. So an easy example of this would be loss aversion. So if we go back thousands of years, we weren’t the only humans on the block. We weren’t the only human species on the block, we had a group called the Hobbits in Indonesia. We had the Neanderthals which we’re perhaps more familiar with in Europe, the Denisovans in Asia. And the reason why scientists believe that we outlasted these different groups of humans is that we were more fearful.
Steve Pomeranz: Hm-hm.
Daniel Crosby: We were basically more cowardly or more chicken-
Steve Pomeranz: [LAUGH]
Daniel Crosby: [LAUGH] Than some of the other folks who were there. And so where they were sort of brave and overconfident and might have taken some sort of unprotected risks, we homo sapiens were a little more fearful, and if things started to look dicey, we moved on. So this loss aversion is what caused us to spread our genes and live on long enough to reproduce. And so it’s been a great boon for us, as a species, but it makes us a poor investor. And that’s one of many examples that are covered in the book.
Steve Pomeranz: A statistic that I continually, and I actually continue to say, is that we feel the pain of a loss two-times as a much as we feel the pleasure of a gain. You subscribe to that and do you think that’s part of what you’re talking about?
Daniel Crosby: Yeah, it’s nearly two-and-a-half times as much. I absolutely subscribe to it on anecdotal and experimental means. I was at a casino recently; I was speaking at a casino of all places to speak about great investment decisions.
And it was part of a hedge fund conference and my family was there with me, so we retired early. But some of these hedge fund managers were out doing their thing late into the night. So the next day at the conference, I speak to these enormously wealthy guys and say hey, how’d you do at the tables last night? One of them says, I was up 500 bucks. And I say, oh, good for you, and he goes ah, doesn’t change my life. And another gentleman to my right was down about an equal amount and I said, get them next time sort of thing. And he said no, this trip is ruined.
Steve Pomeranz: [LAUGH] Oh, my God.
Daniel Crosby: And this is an enormously wealthy, I won’t name names.
Steve Pomeranz: Yeah.
Daniel Crosby: But this is an enormously wealthy individual and losing $500 was ruining the whole trip for him.
Steve Pomeranz: Yeah, so that’s more ego. When you talk about ego in the book, this fear drives us to poor decision-making. Is this quote in your book, “in times of financial stress, people lose 13% of their IQ”? That seems a pretty amazing statistic. What does that do to us?
Daniel Crosby: So I would give the caveat, as well, that not all of us have 13% to spare, right?
Steve Pomeranz: To give [LAUGH].
Daniel Crosby: To give, yeah. So yeah, we found that when people are under financial duress, their cognitive-processing power drops pretty significantly. Which is—you know this as an advisor—we have least access to our financial knowledge when we need it most.
Steve Pomeranz: Yeah.
Daniel Crosby: So at the very moment we need to be remembering the good lessons that we’ve read about or learned from an advisor, we have least access to them. And this is a very consistent finding, that at the very moment of struggle, your brain is out the door, your willpower’s out the door, your emotions are out the door. So this is why I’m such a big advocate for, a: automating your investment life, that you’re automating your good decisions. And, b, outsourcing and working with a financial professional.
Steve Pomeranz: The backup to this idea was studies that looked at the decision making of judges who were hungry before sentencing, and people who fast. Tell us briefly about that.
Daniel Crosby: So it looked at different points during the day. And it was a study done on Israeli judges over a ten-month time period; it looked at over 1,100 different cases. And it mapped either the stringency or the leniency of the judge’s rulings at different points during the day and tried to see if they were basically making consistent decisions through the course of the day. What they found is early in the morning, you start with about a 65% chance of being paroled. But if you were the last person seen right before lunch, you had a next to zero chance of being paroled, because the judges are hungry. And they’re feeling hungry, as we say here in the deep South, right?
They’re hungry and angry, they’re feeling punitive. Then after they eat lunch, we jump up again to about 60, 65%. And that continues to decline until snack-time when it jumps up again, and then it falls for the rest of the day. So again, the point I’m trying to make here is this: if you ask these judges, how did you arrive at these decisions, they would point to their big brains and their years of learning and judicial precedent and any host of things besides not having had a doughnut and coffee, right?
Steve Pomeranz: Yeah.
Daniel Crosby: It would point to a million different factors besides the most salient factor. And so all of us, we’re possessed of these bodies that are consistent with the theme of our conversation today. We’re presented with these bodies that are, on the one hand, miracles that are unrivaled by our best science, and on the other hand, get profoundly stupid if we just fail to eat enough. So we have to understand that our bodies, our brains, our society are all conspiring to lead us to make poor financial decisions.
Steve Pomeranz: We talked about ego before, overconfidence. People are especially more positive, you say, especially men—and this I really enjoyed—who when surveyed thought themselves friendlier, funnier, and better looking than average. And you go to say that the average man seems to think he’s two sit-ups away from dating a supermodel. [LAUGH]
Daniel Crosby: Right, so the interesting point here is, on these measures of friendliness, athleticism and good humor, the men in the study thought that they were—94 to 100% of them, depending on which of the variables you’re looking at—thought that they were above average in this respect. And that is not how averages work, right? [LAUGH]
Steve Pomeranz: Yeah.
Daniel Crosby: You don’t get 100% of people who are above average. And again, we see that this is something that has had a salutatory effect on humankind over eons of maturation and development. The fact that we’re overconfident helps us get out of bed in the morning. It helped me talk to my wife who I had no business talking to, right? I mean, it helped me to start a small business even though most small businesses fail.
Steve Pomeranz: Right.
Daniel Crosby: Overconfidence leads us to start restaurants and businesses. It leads us to do all manner of things that are good for society, that are probabilistically speaking, unlikely.
Steve Pomeranz: Yeah.
Daniel Crosby: But we have to separate that from our investment lives. You can be special, you can be overconfident in other places. Go take that big shot, go talk to the pretty girl, go start that business. But do not think that the rules don’t apply to you when you’re selecting funds or trying to make investment decisions because they absolutely do.
Steve Pomeranz: Yes, so you state that Wall Street is Bizarro World in your interview. I mean, everything that you are used to, every behavior you’re used to using which has created a success in your life or has done other good things for you, don’t necessarily work in the world of Wall Street and give me an example of how that’s so.
Daniel Crosby: An easy example is just action, if you think about trying to get stronger. So I’m trying to increase my bench press this year, that’s one of my goals. And so what I’m doing is I’m lifting more weights; I’m spending more time at the gym. If you want to become more intelligent, you should read more books and spend more time in libraries. But the findings suggest that if you want to make more money, the thing that you should do is nothing.
Steve Pomeranz: Nothing, yeah.
Daniel Crosby: [LAUGH] And we find in 19 different countries that I examined, we found that the more people traded, the more people watched financial news, the more people tuned in, the worse they did. And so it’s profoundly counter-intuitive to think that everywhere else in my life more effort brings me more good things. But here in the world of money, I should blow up my TV and never check my statements and never trade. It’s quite a thing to get your head around.
Steve Pomeranz: Well, as an investment advisor that I am and I’ve been doing for so many years, I think people expect me to do things. They expect me to trade more, to anticipate economic movements and stock movements, and somehow kind of get them set up for protection or for opportunity. And my monitor is, no, we’ve built this ship solidly, we’ve thought very hard and deep about what the structure is. We’re not really, we don’t want to change it, we’ve kind of thought this through. And then I say, doing nothing is the right thing to do, of course, unless you’re a teenager. And then doing nothing is really the wrong thing for you to do.
Daniel Crosby: [LAUGH]
Steve Pomeranz: Get off the couch and go outside. But there is this expectation that we should be doing something all the time.
Daniel Crosby: Yeah, but you can see, so on the one hand, you’re absolutely right and the counsel you’re giving your clients is sound counsel. But you can also see why people go, wow, I’m paying this person to tell me to do nothing? Well, yeah, kind of you are, [LAUGH]
Steve Pomeranz: And hold you back.
Daniel Crosby: You are-
Steve Pomeranz: Yeah.
Daniel Crosby: To hold your hand and to see you through those difficult times-
Steve Pomeranz: That’s right.
Daniel Crosby: And in the laws of wealth, my last book, I talked about, I spent a whole chapter talking about the research that shows that people who work with a financial advisor do about 3% better per year than those who don’t.
And over the course of 15 plus years, it leads to people who’ve worked with an advisor for the long-term, having more than two-and-a-half times the wealth of their no-advice peers. But when we looked at the drivers of that, it’s basically saving someone from three or four catastrophically stupid decisions over a lifetime. And it’s a funny thing to say, hey, I’m going to make you three times as rich by basically helping you to do nothing and not shoot yourself in the foot, and the research bears it out.
Steve Pomeranz: My guest, Daniel Crosby, the book is The Behavioral Investor, and we’ll be back momentarily to finish this conversation.
Steve Pomeranz: I’m back here with Daniel Crosby. He’s the author of The Behavioral Investor, which is a look at how psychology should inform the art and science of investment management. We were talking about Wall Street and how really doing the opposite of what you think is right, is probably the best way to go about operating on Wall Street.
One very famous idea that came from Peter Lynch, who was a very successful money manager in the 80s of the Fidelity Magellan Fund and wrote a number of books, is that he says that you should buy what you know. You should, and you go into a store and you see a product that you really like, and you understand the product. You should buy that company. You say that that’s not a good idea, why is that?
Daniel Crosby: Yeah, with profound deference to a guy who has a lot more money than me, right? [LAUGH] I think it’s a very bad idea. And there’s two reasons why. So the first is that it’s something we’re already prone to doing. If you look at Greece during the Greek debt crisis, the average Greek investor had more than 80% of his or her money in Greek stocks. And when you think about the Greek economy on the world stage, I mean, the Greek economy on the world stage is smaller than a small American state.
And you would never say invest 80% of your wealth in stocks from Rhode Island. And so you’re very, very undiversified, and we even see that geographically. People in the Northeast tend to be overweight financials. People in the Midwest tend to be overweight agriculture. People already confuse what they know with what is good. And they already think that, well, since I’ve heard of this, it’s not risky. And this leads people to be overweight their home country, overweight their industry.
And if you think about a farmer in Kansas who is loaded up on agricultural stocks because that’s what he’s familiar with, his farm depends on farming, his livelihood depends on farming, his real estate depends on farming. And now this portfolio is overweight farming. It’s just you’re taking excessively concentrated bets if you’re buying what you know. The second reason is we found that financial education doesn’t work when it’s specific to holdings that you have in your portfolio.
So if you teach an investor high-level truths about stocks and bonds and different asset classes and how they work together and what a diversified portfolio looks like, that’s powerful. People tend to remember and implement those learnings. But if you have someone who’s holding Apple stock, and you try and teach them about Apple stock, that gets filtered through the lens of, hey, I own this, I have my money in this. And it distorts the learning. So it’s an interesting parallel. So there’s a couple of reasons why I think you should not know what you own and why you shouldn’t buy what you know, which is because you tend to already be overweight in what you know. And knowing what you own, paradoxically, makes you hard to teach about to do with what you own.
Steve Pomeranz: That’s fascinating. I think there’s some argument that can be said by stating it a different way. And that is Buffet’s idea of investing within your circle of competence. Is that different?
Daniel Crosby: Yeah, so the circle of competence investing reminds me of low ego, right? This is just saying, look, if you don’t understand something, then don’t venture into those waters. And I think that that’s good advice for the average investor who may be tempted to get into something like cryptocurrency, which they have maybe heard of but couldn’t explain to you in a quick summary what the blockchain is or how it operates, right?
So that sort of circle of competence investing would keep you out of that. Buffett would never say if you work at Coca-Cola, load up on Coca-Cola stock because that’s your bread and butter. So I think this idea of circle of competence is a check on ego. Whereas, what I’m talking about is a check on another human tendency, which is the status quo bias, which is this propensity to confuse what we know with what is safe.
Steve Pomeranz: Yeah, makes sense. So let’s take a look at this problem with our lessening IQ under stress. This is important to me. So there’s this poem from Rudyard Kipling, “If you can keep your head when all about you are losing theirs then”—and it goes on and on and on. Actually, I just reread it before this interview, and it’s actually quite beautiful. And it describes a lot more things than just that, but that one quote is used a lot—“then you will be a man, my son”—is how it ends. It also says, by the way, if you can wait and not be tired of waiting, which is another thesis in your book as well, is to be patient and to slow things down. Describe that for us.
Daniel Crosby: Well, one of the reasons why we found that slowing down or sort of sleeping on a decision was impactful is because it lessens the degree to which we fall prey to status quo bias by about 32%. I think I’m getting that stat right.
So again, people, when they’re under pressure, tend to do what they’ve always done. They tend to do what’s easy or comfortable, which may or may not be the right thing. So slowing down that process actually helps us to make more deliberative decisions, better decisions. I also cite research in the book (which was one of the more fascinating studies I found) which found that people who are bilingual make better decisions when they’re thinking in their non-preferred language.
So if you speak Spanish and English, and you have to make a big decision and English is your native language, you may try and mull that over in Spanish because it causes you, again, to be less emotional, more intentional, more deliberative, slower. And that led people to make better financial decisions. So again, slowing down the sort of reflexive knee-jerk reactions which we all have around money is nothing but a good thing.
Steve Pomeranz: So sleeping on it is a good idea?
Daniel Crosby: Sleeping on it is a good idea. Talking it over with a trusted advisor is a good idea. Thinking about it in Spanish is a good idea.
Steve Pomeranz: [LAUGH] Lots of luck with that, for me anyway.
Daniel Crosby: [LAUGH] For me too.
Steve Pomeranz: [LAUGH] Sometimes when I’m driving to work, I’ll have CNBC Radio on. And I’ll hear someone spell out a thesis or something. And the worst thing that can really happen is that I really understand what he’s saying.
Daniel Crosby: [LAUGH]
Steve Pomeranz: Because, to me, that makes perfect sense. The first thing I want to do is come in the office, I want to do that. I want to execute that because I think I understand it because the person has made such an eloquent case for it. What, of course, I do, I do nothing. And what I realized is that there is so much behind understanding what this person was actually saying, that a 30-second clip and then going to commercial is really not enough. So one of the dangers is the thought that you’ve understood something so completely, so quickly. Has that ever crossed your mind?
Daniel Crosby: Yeah, so I have a whole piece in the book where I talk about how we think in stories. And I cite research out of Princeton that shows when two people are sitting across from each other, you and I are sitting across from each other, and they do maps of our brain, they hook us up to an MRI machine. And our brains don’t look altogether too similar, because we’re different guys having different thoughts. But then if you start to tell me a story, our brains effectively sync up. The brain activity of our two brains mirrors one another. And it’s effectively as though you’ve opened my head and dropped your brain in my head.
So narrative and stories are enormously powerful and very seductive. But they’re usually far too simple. And what I love to do is look at my, [LAUGH] I’ll look at my iPhone stocks app in the course of a given day, like many we’ve had in the last month or so that have been relatively volatile. And you’ll say, it will start the morning up half a percent. And it’ll say, stocks rise on enthusiasm about midterm elections. And then you close the day out down 1%, and it says, stocks fall on terror over midterms.
Steve Pomeranz: [LAUGH]
Daniel Crosby: And it’s like, well, which was it, guys? So we’re always putting stories, stories are chasing reality. They’re not driving reality. They’re chasing posthoc, what has already occurred.
Steve Pomeranz: Yeah.
Daniel Crosby: And the more we can understand that and not fall prey to these seductive narratives, the better off we’ll be.
Steve Pomeranz: Oh, unfortunately, we are out of time, fascinating stuff. Daniel Crosby, author of The Behavioral Investor. Anybody who wants to invest and wants to get a handle on it and get it right this time, should check out this book, The Behavioral Investor. Daniel, what a pleasure. Thanks for joining me.
Daniel Crosby: My pleasure, thank you.
Steve Pomeranz: To hear this interview again, don’t forget to go to StevePomeranz.com. And while you’re there, sign up for our weekly update, where you will get this and all of our interviews either in transcript form or summary form. Or you can actually listen to it at your convenience, and you’ll find that at StevePomeranz.com.