Wall Street is “Bizarro World,” and Peter Lynch’s buy-what-you-know investing strategy is “profoundly dumb advice.” These are the — safe to say — irreverent viewpoints of psychologist and asset manager Daniel Crosby, who has taken a deep dive into “investor misbehavior.” AARP touts him as “a financial blogger you should be reading.”
The frequent industry speaker has sound reasons behind his surprising opinions, and he discusses them in an interview with ThinkAdvisor.
Founder of Nocturne Capital, Crosby’s investing approach is grounded in behavioral finance. As a self-described “evangelist,” he urges clients and advisors to apply that discipline’s concepts to daily life.
In the interview, Crosby, 38, focuses on a theme that can best be described by the opening verse to Paul Simon’s classic, “Feelin’ Groovy” (aka “The 59th Street Bridge Song”): “Slow down, you move too fast.” The doctor’s point is that investors should “pause, slow down” and be guided by the old saying, “This too shall pass,” because mean reversion in the stock market is a fact of life.
FAs are invaluable to keeping clients from making potentially costly investing errors, Crosby holds. He even suggests that they have clients sign a “Behavioral Policy Statement” promising to behave in a way that maximizes wealth growth.
The RIA’s niche is ultra-high net worth clients, for whom he constructs highly customized portfolios. “Money, Mind and Meaning” is his popular podcast. For financial advisors, he offers an online Behavioral Finance Certificate program, in which they can earn 5.5 continuing education credits.
ThinkAdvisor recently interviewed Crosby, on the phone from Atlanta, where Nocturne is based. Among other aspects of behavioral finance, he explored the four most significant biases out of a total 117. The CNBC contributor presents at more than 50 industry events annually and has given three TEDx talks. Topics include “Influence and Persuasion for Financial Advisors” and “Bear Necessities: Keeping Your Clients Calm When Markets are Volatile.”
Here are highlights of our interview:
THINKADVISOR: You write that if someone feels passionate about an investment idea, they probably haven’t thought hard enough about it. Please explain.
DANIEL CROSBY: If you’re excited about it, it’s a bad idea. I try to get advisors to come up with “pre-commitments” with their clients because there’ll be a day when a client comes in excited about some investment, and that excitement is almost a dead giveaway that it’s a dumb idea.
What sort of “pre-commitment”?
Just like advisors and investment managers sign an Investment Policy Statement that [essentially] says, “I’ll adhere to the following standards in the management of your money. That’s my promise to you,” my suggestion is to solicit a reciprocal promise in writing from clients: a Behavioral Policy Statement that says: “Our success is going to be a two-way street. It will depend on my doing wise things and being a good steward of your money. But it will be equally dependent on your behaving in a way that maximizes our ability to compound your wealth.”
Why do you call Wall Street “Bizarro World”?
Because the rules of the day and the rules of Wall Street deviate from each other pretty systematically. All the things that make sense in everyday life are turned on their head in Wall Street. In everyday life, we think in terms of the present more than the future, but that’s flipped in Wall Street. In the everyday world, if, for example, you want to be smarter, you read more books. But in Wall Street, if you want to make more money, you need to do less.
The brain leads us to exercise low levels of risk when risk is actually quite high, you write. What’s the solution?
We think that because the economy may be good right now, it will be good in the future; or if things are bad, they’re never going to get better. But given the market’s tendency to mean-reverse, the exact opposite tends to be true. The [best attitude for] in investing is “This too shall pass.”
Why is that a good mantra?
It’s heartening in bad times and chastening in good times. Anything that cause you to pause and slow down is good.
“Emotion appears to be the enemy of great investing,” you say in the book.
Yes. Emotion undergirds every decision we make, most of all, decisions about money. It’s a conundrum. But we’ve learned from studies that if we’re able to suppress that emotion, we make better decisions.
The average investor loses 13% of their IQ “in times of financial duress,” you write. That’s terrible!
We tend to be our dumbest when we need to have our wits about us. That’s why financial advisors are important.
The original form of risk management was “our ability to reason emotionally: If something felt wrong in our gut, we should avoid it.” But with investing, you write, we need to “tune in to slower ways of approaching the market.” Why?
We tend to be less discerning when we’re in a state of heightened emotion. Good investing is probabilistic investing. In a bull market, like the one we’re in now, people scoff at risk management and the idea that things will ever go poorly. That’s why I love the “This too shall pass” idea because right now, [the strategy could be] “I may want to de-risk a bit since this won’t last forever.”
You write that a risk management technique that Warren Buffett uses is asking: “How likely is it, and how big is it?” What else comes into play?
If something is [even] fairly improbable, it makes sense to hedge against it. So if you’ve got a 1% chance of a 50% decline, it’s still something you may want to think about.
When FAs ask clients to do things that are difficult — like saving — are they approaching investing in ways that are challenging biologically?
Absolutely. Advisors effectively earn their keep by asking clients to do things that are 180 degrees opposite to their brain’s wiring and then holding them to account for those things. That’s why advisors are worth the money [they charge]. We’re wired to experience pleasure in the moment, and we have only a very weak sense that there will be a future version of ourselves.
There are 117 biases and heuristics — mental shortcuts — that can prevent investors from making “optimal decisions,” you say. What are the most significant?
Ego: overconfidence — to believe that bad stuff happens to other people and that good stuff happens to us. Emotion: to allow the emotional state we’re in to color our perception of risk and reward. Attention: to confuse salience with probability; and Conservatism: our preference for the status quo and to have things as they’ve always been vs. trying new things.
Therefore, you say that Peter Lynch’s strategy of “buy what you know” is “profoundly dumb advice.”
Better advice is: Buy what you don’t know. It goes back to our tendency toward conservatism. We’re already predisposed to buy what we know. Investors are wildly prone to that; there’s no need to tell them. You see this in home-bias investing: Most investors have 80% to 90% of their wealth in the U.S., although U.S. equity accounts for about 50% of the world market.
“As the body deviates from homeostasis” — equilibrium — one’s decisions become worse, you say. Please elaborate.
Our bodies are very finicky and weak. If we’re hot, cold, hungry [etc.] and move away from a homeostatic set-point, our decision-making begins to be altered. A famous study found that the hungrier judges were, the more punitive their sentences became. But after they had a snack, the sentences became more lenient.
You note, too, that people who are fasting “tend to take riskier financial bets than those who are full.” Interesting …
Right. And there’s also a study showing that people with full bladders who “held back” when they needed to pee [generalized] to investment decision-making: Those people were able to show better risk control.
Taking financial risks can cause actual bodily pain, you maintain.
Those who are investing in a contrarian way — value investors — register physical pain. If you take a position that’s contrary to the rest of the group, it causes physical pain because acting in accordance with a group serves us well in just about every other capacity but not [in that case].
Warren Buffett times the market and is doing so today, you point out.
Yes. This goes back to my belief about “This too shall pass.” Two of my fundamental beliefs about the market are mean reversion and that forecasting is nigh impossible. I know the market is expensive now, but I don’t believe it will stay like this forever — though I don’t know when it will mean-reverse. But medium-term, big returns like we’ve had seem to be followed by medium-term scant returns. And that’s my expectation for the next seven years.
“The default behavior” for the behavioral investor should be “patience, calm and inactivity,” you advocate. Is rules-based investing the answer, then?
Rules-based investing is our last best hope. There was a [large] study of more than 200 studies of rules-based decision-making vs. human discretionary decision-making. It found that 94% of the time following a simple algorithm — a simple set of rules — outstripped human discretion, which included expert-level human discretion. That’s doubly true of finance because if you’re following a rules-based model, it’s likely to be less expensive [in fees] as well. I believe that rules-based investing is the way to go.
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