THE BEHAVIORAL INVESTOR (BY DANIEL CROSBY)


You were born to fit in, but investing requires you to stand out. You are wired to protect your ego, but to succeed in the markets, you must suppress it. You are programmed to ask why, but in investing, you must learn to ask: why not? This is The Swedish investor. And this video is a top five takeaways from the book “The Behavioral Investor”. By Daniel Crosby Let’s dive in. Takeaway number 1: 4 behavioral risks, crushing your investment returns. The greatest financial intellect in the world is nothing if it’s not paired with a self understanding to match. Therefore, we will start out this video by presenting four different kinds of behaviors that you must avoid if you want to learn the Mida’s touch. Ego Men are especially vulnerable to this behavioral risk. Almost every one of us (one study actually had 100% as the result) think that we are better than average interpersonally, and 94% of us think that we are more athletic than average. Statistically I imagine that it would be difficult to prove how 94% are above average. In investing, this hurts us in many ways. I’m not referring only to men anymore – but yes, we suck at this the most. Among other things, ego causes us to seek out information that strengthen our beliefs instead of questioning them. In this search, we are not looking for truths. Rather, we are looking for comfort. Unfortunately, mr. Market is not a comforting person. Conservatism A majority, 55%, of all family violence occurs in homes of alcoholics. Many children are hurt emotionally or physically growing up in such families. Therefore, one would assume that these children would take extra measures to avoid ending up in similar situations as grown-ups. The statistics tells a different story. As many as 50% of children of alcoholics end up marrying one themselves. This is caused by conservatism. We prefer “the devil that we know”. This behavioral risk causes one of, if not the most common investing mistake of all: holding on to losing positions. Attention We pay too much attention to stories, and too little attention to mathematics and statistics. A good story, or a terrifying one for that matter, sticks. Numbers …. they don’t. Because of this, many problems arise. For instance during market crashes. It’s near impossible to remember that corrections and bear markets are common and nothing to worry about, while CNBC, Fox News and The Wall Street Journal are doing live streams 24/7 about how the world is about to burn to ashes. Emotion. An interesting study was conducted on students where their sexual preferences were examined. 19 questions were asked to decide their propensity to engage in “odd” sexual activities, cheat on a significant other and having unprotected sex. Normally, students would shy away from such activities. Now the same 19 questions were asked to another group of students, who was shown pornographic images, aimed at emotionally arousing the participants. The results were astounding. The students were 72% more likely to participate in “odd” sexual activities, 136% more likely to cheat, and 25% more likely to not wear a raincoat. Prevention, protection and morale disappeared from their radar screens! Likewise – when you experience strong emotions while investing (not necessarily sexual ones) the set of rules that you normally obey in the market will fly out the window. It’s not so much that you suddenly disregard their value, but rather, you forget all about them. Takeaway number 2: How to manage the four behavioural risks. Your brain is a miracle. And even the best machines/AIs can’t compare to it in most aspects. But! It’s a miracle for a different time and place than investing in the 21st century, as we saw in the previous takeaway. Let’s find out what we can do to restrain ourselves to cope with the difficulties that we have. Ego Spread the wealth Realize that even thorough analysis can’t protect you from unexpected events. The inspiring and amazing CEO that was part of the reason as to why you made a specific investment ,might suddenly die from a heart attack. Therefore, spread your capital over at least a couple of investments. Risk (measured as the volatility of returns) quickly deteriorates with only a few holdings. Those who can, teach If you are truly comfortable with an investment decision, it should be easy to convince someone else of your choice. Test it! Guess again Make it your mission to always question your most important assumptions. If you decide that Apple is a great buy because you think that it has great potential in the 3d printing industry or … or whatever, come up with a couple of reasons as to why you could be wrong. Conservatism Procrastinate (just a little) Subjects pick a default option in 82% of the cases when in a hurry, but only 56% of the time when they get to think for a moment, according to research. Taking your time will allow you to not just be another sheep in the herd who picks the default option in the market. No regrets Regrets can cause paralysis ,which will have a serious negative influence on your investment returns. For this reason, you should invent and implement a rule-based system for picking stocks. Instead of kicking yourself for your bad picks, you now have a scapegoat. It wasn’t your fault. It was the system! Better improve it for a round 2! Flip the script According to Charlie Munger, who is Warren Buffett’s right-hand man: you must always invert. By this, he means that you can investigate a problem more in-depth if you flip it around. Instead of asking yourself: why do I want to invest in Tesla? If you already are bullish on it, ask yourself: why wouldn’t I want to invest in Tesla? Attention Play the odds, ditch the story Here comes another caveat to financial news reporting during market turmoil. The stock market has an expected return of about 7-8% per year (if we are to trust about 200 years of history). This means that for every $100 you invest you get 7 to 8 dollars back every year on average. Therefore, don’t run for the exit door during a bear market just because the new story is telling you that the sky is falling. It’s not. And if I’m proven wrong here for some reason …. let’s just say that at that point the least of your worries will be that you invested in the stock market. Look for simple solutions The investor sometimes ends up in a situation where he can’t see the forest for the trees. Certain specifics about an investment might consume so much energy that he cannot see the whole picture anymore. Once again, a rule-based system that takes this into account is the solution. Size matters Let’s talk about men and their egos again. Some men with gigantic egos also have gigantic … No. No wait … What was this point about again? What I was about to say was that it’s not just important to consider how likely a scenario is, the size of the impact if the event happens is of the same importance. Consider these two stocks. Which one makes for the best investment? I’ll leave you to discuss this in the comments. Emotion Meditate Emotions around financial markets can usually be categorized as either fear or greed. Turns out that meditation is AWESOME when it comes to taming both of them. Automates, automate, automate At this point this advice might bore you a little bit, but I’ll explain it one more time: to become a great behavioral investor, you need a rule-based system. This goes for countering emotions to. Learn to recognize emotions If you can learn to identify your emotional state, you can also learn to avoid investing at times when you are more inclined towards making bad decisions in the market. If you feel either hungry, angry, lonely or tired, stay away from your stock portfolio. Takeaway number 3: How to design a winning rule-based system You might have already noticed, but a common denominator and solution to many of the problems caused by behavioral risks in the market can be mitigated by implementing a rule-based system for your investment approach. Now now. This does not mean that we are supposed to turn the analytical and awesome process of picking great investments into a mundane task, that can be implemented without creativity or analysis. It means setting up a framework while in a sober state, so that when you experience either a blown up ego, a paralyzing conservatism, a temporary attention disorder, or an emotional roller-coaster, you can still utilize your full knowledge and wisdom. The process of setting up such a framework is often both intellectually challenging and rewarding. A winning rule-based system has three different factors that it must satisfy. 1. Empirical support This is the most obvious of the three points. Your rule-based system should prove profitable when you investigate how it performed historically. 2. Theoretical support If you investigate tons of data sets, you will end up with correlations (that is data moving in tandem) even though they have nothing to do with one another! For instance, researchers have found a 0.99 correlation, which means almost perfect correlation, over the time period of 1981 to 1993, with something as silly as the S&P 500 and butter production in Bangladesh! For this reason, it’s not enough with just empirical support. It must also make intuitive sense that your system should work. 3. Psychological pain The final, and by far most interesting point that Daniel Crosby presents for a winning rule-based system, is that it can only withstand the test of time if it’s also mentally difficult to stay true to. Otherwise, as soon as the system is discovered and publicly spread, its profitability will vanish almost immediately. Let’s end this video with two different strategies which fulfill all of the three points just mentioned. Takeaway number 4: Why value investing works The first system that meets all of the three requirements is value investing. Benjamin Graham is often credited with being the inventor of this approach, and it’s been made famous by Warren Buffett. Basically, it’s all about buying stocks that are priced lower than the underlying value of the company. Typically, such stocks have low valuations of assets and earnings. Moreover, they’re not the type of companies to be mentioned (at least not in a positive manner) in the financial news. So why does it work? 1. It has empirical support This has been shown over and over and over again. For example: low price-to-book stocks outperformed high price-to-book stocks in 100% of the times in five year period. Low price-to-book stocks returned almost three times more than the expensive stocks during 1963 to 1990. Low P/E stocks returned 5% more annually than their benchmark index. 2. It has theoretical support Would you rather pay $10 to get $1 yearly or $30 to get $1 yearly? Value investors would prefer the first alternative, which does make intuitive sense. 3. It’s mentally difficult to implement Value stocks are cheap for a reason. It could be because the company in question has been involved in a scandal recently, it’s operating in a market which is viewed as unattractive, or simply because profits have been declining as of late. No matter the underlying reason, these companies are frowned upon by most of the investment community, and to swim against the stream is difficult. Takeaway number 5: Why momentum investing works Isaac Newton stated that “an object either remains at rest or continues to move at a constant velocity”. This law of physics translates to the financial world as well. A stock which is moving upward or downward, also tends to keep moving in that direction. This is the basic of momentum investing. Let your winners run and cut your losses short is an expression that momentum investors worship in one way or another. Let’s investigate why it works. 1. It has empirical support A few examples here. Stocks which performed better than the median in one year tended to do it in the next year as well. Winning stocks continued to outperform losing stocks on average during the following six to twelve months. And finally, momentum effects have persisted in the US since 1801. 2. It has theoretical support Greed could be one potential explanation for the observed empirical support. If my friend makes money on a specific investment, I want to do it too. A slow reaction to publicized data is another possible explanation. It takes a while for the investing community to process new information 3. It is mentally difficult to implement We rather stick with our loosing stocks, and sell our winning ones. Although counterproductive when it comes to making profits, it makes sense from a psychological perspective, as every stock sold at a higher price than the buying one is a “secured profit”, and losers that haven’t been sold off yet still have a chance to transform into profits. Typically, they don’t. So, what do you think about the takeaways? Which one of the behavioral risks do you find the most difficult to manage? Do you have additional tips on how to overcome them that I didn’t mention in this video? Please share your thoughts with us in the comments. If you haven’t yet seen my newest video, be sure to do that. If you are interested in hearing more about biases and behavioral risks in the market, be sure to check out my mini-series of Daniel Kahneman’s “Thinking Fast and Slow”. See you next time!