Charles Rotblut leads a class in AAII's new Essential Investing Video Course. Go to https://www.aaii.com/ves for more information and to subscribe.

Psychologist and behavioral finance expert Daniel Crosby, Ph.D., and I recently spoke about the types of behavioral risk investors face and what they can do to avoid them.
—Charles Rotblut, CFA

In your book, “The Behavioral Investor” (Harriman House, 2018), you grouped the various biases and mental shortcuts influencing investors’ decisions into four types of behavioral risk. Could you provide a brief overview of what those types of risk are?

One big piece of my research has been taking the universe of biases and attempting to create a more cohesive universe that has a higher impact. There are nearly 200 identified biases. Since a lot of them have common psychological underpinnings, I asked, “What are the handful or two handfuls of common themes that unify them?”

I found four things: ego, emotion, attention and conservatism. Ego is the tendency for us to be overconfident. Emotion is our tendency to conflate our affective state with reality. The third one, attention, is our tendency to confuse high salience with high probability—that is, high luridness or scariness with high probability. Finally, conservatism is our preference for things that we know and our preference for the status quo and inaction over action.

In terms of ego, you mentioned overconfidence. Obviously, if someone’s overconfident, they may not necessarily perceive themselves as being overconfident. Any suggestions on how somebody might acknowledge that overconfidence is affecting their decisions?

Navigating the psychology of markets is fraught with paradoxes. One of them is that the people who are least sure that they are overconfident are the ones that ought to be most sure. One marker for overconfidence is, ironically, feeling that you’re not overconfident. This is something that impacts nearly everyone. Frankly, there are really only two states you can find yourself in: You can be overconfident or depressed. There’s not much in the middle. So, in terms of identifying it, one thing is just understanding that if you don’t think you’re overconfident, you probably are.

A second thing I would suggest is that investors look at the data. In the book, I cite research that shows that a third of people who think that they’ve beaten the market have actually underperformed by 5%. Another quarter of people who think that they’ve beaten the market underperformed by 15%. A second study I cited found that the correlation between self-reported investment performance and actual investment performance was indistinguishable from zero.

One of the things that we can do is just look at the numbers. Compare them to reality and ask, “How, objectively, am I doing?” Most of us actually don’t know the answer. In the absence of that data, we just assume that we’re doing very well.

You’ve also suggested considering different scenarios in terms of possible outcomes. If somebody’s investing by themselves, they won’t have a team they can bounce ideas off of. So, how does an individual investor prompt themselves to think about various scenarios and possibly apply some type of odds to a certain scenario occurring?

There’re so many moving parts in any kind of investment decision. But to use an easy one, I get approached by DIY investors fairly consistently who say, “Hey, I have a large allocation to XYZ individual equity. What do you think about it?” I’ll respond by saying, “Well, the average stock dies. The average stock has a catastrophic loss. More than half of stocks suffer losses of 75% or greater. So, on average, I think your precious holding is going to crash and burn.”

It’s knowing numbers like this. It’s knowing the odds. Only about a quarter of stocks have accounted for about nearly 100% of the market’s gains. Fully 50% of stocks have fallen to nearly zero. Another quarter have been flat.

It’s understanding probabilities like this that leads you to acts of humility like diversification. For me, diversification is the ultimate nod to low ego and is the way that we can say, “I have no idea what’s going to happen. I’m being appropriately circumspect about my ability to predict the future, and so I’m just going to spread my investment dollars around.”

One more thing we can do to check our ego is to teach. One of the reasons that I write books is to figure out what I think. It’s less about convincing other people that I’m right and more about me figuring out for myself what I believe. You think you know something really well until you try to teach it to a child, teach it to a novice, write a blog post about it or speak to a church group about it. So, for anyone who thinks that they have this thing nailed, I would also suggest trying to teach a friend about it. You’re going to identify gaps in your knowledge that you can go back and reinforce.

That’s a good idea. What about the other side? What if someone doesn’t have confidence in their investing skills?

Well, I think we have to parse the language a bit. If you feel like you have a knowledge deficit, that’s one thing. If you feel like you need to know more about the world of investing, you can read a book. If you have a clinical lack of confidence in yourself, that’s another conversation.

It’s interesting because what we find when we look at gender differences is that women are much less confident in terms of measures of investor confidence. They don’t think they know what they’re doing at the same level that men do. Yet, women outperform men in every conceivable way. They’re less prone to going to cash. They’re more likely to stay the course. They’re better at weighing probability. Women outperform men in retail and professional contexts. And yet, they lack confidence. So, I’m not convinced that a lack of confidence is necessarily a bad thing.

If you lack knowledge, go seek out that knowledge. But if you’re a little bit tentative, if you’re a little bit hesitant, on the whole, the research suggests that it leads you to be more patient, less active and better diversified. That’s all good.

Regarding emotion, you wrote that people tend to underestimate its effect. How should someone react to or manage the impact of their emotions?

Emotion is a tricky thing. The chapter about emotions was probably the chapter I was most excited to write because I felt like there were a lot of misconceptions.

On the one hand, we see that people with damage to the emotional processing centers of their brains have a hard time making basic decisions. They have a hard time picking out which suit to wear or which flavor of ice cream to have. Yet they make very good investors and very good gamblers.

There are a couple of things we learn from these traumatic brain injury studies. First, we realize that every decision has an emotional undercurrent to it. Even for something as simple as “What do I have for breakfast?” Emotion guides even low-stakes everyday decisions in ways that we don’t fully understand. The fact that emotion is ever-present is one thing I think we need to understand.

But emotion—extreme emotion—also seems to be the enemy of good investment decision-making. While there are some people who would suggest that you tap into your emotions almost as a sixth sense or a premonition about what’s going to happen, I have not been able to find a single thing to support that in the literature.

So, we see that people with brain injuries are better investors. In people who speak a second language, when they have to consider a financial or investment decision in their non-dominant language, we see that they make better choices than when they’re thinking in their dominant language. The reason for this is because they have to be more thoughtful, they have to be slower and more deliberative, when they’re speaking in their non-dominant language. So, this slows down emotion. It slows the train down and leads them to make less-reflexive decisions.

Everything I found in my research says that emotion is always part of it, but extreme emotion should be avoided pretty scrupulously. I think that being a systematic, rules-based decision-maker and automating your process to the extent possible is the easiest answer for managing emotion.

What if somebody just finds themselves being nervous? Maybe they turn on CNBC and get spooked by the news of the day. Any suggestions on how to cope?

The first thing is to avoid them. You would not counsel an alcoholic to spend a bunch of time in bars. The research shows pretty consistently that our willpower is a much worse predictor of our behavior than our environment. We tend to overrate our own willpower and think that because we know something, that we’ll do it. There’s a huge gap between knowing and doing. For example, lots of doctors smoke even though they know better. So, the biggest thing you can do is to control your environment. That’s absolutely number one: to just not engage.

If you can’t help yourself or if you stumble upon these things, consider a model I share in the book called the RAIN model. RAIN is an acronym for recognition, acceptance, investigation and non-identification. Recognition is basically saying, “Okay, this is what I’m feeling.” Acceptance is effectively saying, “That’s okay.” Investigation is being curious about the genesis of those feelings. Non-identification, importantly, is decoupling emotion from action.

Most of the time we conflate emotion and action and say, “Hey, I feel A so that leads to B. I’m feeling angry so I’m going to punch you,” or whatever. But that doesn’t have to be the case. And I think when we get curious and candid about our emotional states, we can recognize that we’re feeling a certain way but say, “Hey, look, just because I’m feeling scared doesn’t mean I have to act on that fear.”

The R.A.I.N. Model: Four Steps to Managing Stress

Meditation teacher Michele McDonald developed the R.A.I.N. model, a simple but powerful system for managing an episode of acute stress. Daniel Crosby suggests trying it the next time you feel nervous or emotional:

Recognition: Deliberately observe and name what is occurring in your body and mind. For instance, “I feel my heart and mind racing.”
Acceptance: Acknowledge and accept the presence of whatever you observed above. You don’t have to love it, but fighting will make it worse.
Investigation: Ask yourself what stories you are telling yourself and examine what thoughts are present.
Non-identification: Now that you have recognized, accepted and investigated your stress, you must realize that you are more than your emotions. You can feel something without being defined by it.

Adapted from “The BehavioraI Investor” by Daniel Crosby (Harriman House, 2018).

In terms of attention, it doesn’t seem that people do a good job of assessing the odds of realizing a gain or a loss.

Yes, people certainly don’t do a great job of assessing the odds. There are a couple of reasons why. First, in a very real sense with financial markets, you never walk through the same stream twice. Things are never the same. Conditions are never the same twice. And even if you are a historian of financial markets, you’re never going to quite get the perfect analogy for what you’re experiencing today. So that’s one thing that makes it very difficult.

The second thing is to consider the amount of prior history. If you look back over the last 100 years of downturns—big bear markets in the U.S.—for instance, there are only about 10 of them. So, you’re working with a pretty small sample size. There are a lot of problems with trying to assess probability; it’s very tough.

We get the best sense of probability from a couple of factors. One is that we’re making decisions frequently. The second is that we get immediate feedback.

If you think about eating, you know pretty quickly whether a certain type of food sat well with you because you eat three times a day. But if you are thinking about making a financial decision, that’s something you do much less frequently. Furthermore, the feedback’s very delayed.

You could have bought an index fund a month ago that went straight down in that month. When this happens, you may think to yourself—if you weren’t careful—“Well, that was dumb.” It really wasn’t dumb. You just have to wait for the appropriate feedback time, which isn’t very immediate.

What about a highly damaging but low-likelihood event, say, a repeat of the 2008 financial crisis? If someone’s trying to plan in advance about how to react, any suggestions on what they should include in their notes or in their plans?

I think that people have to frankly prepare for the worst. One of the things we do that is dangerous is confusing rules of thumb with the way things are. People in their planning, using a Monte Carlo simulation or something like that, will say, “Well, hey, I know that stocks give me a return of 10% a year, a diversified portfolio gives me 8%, inflation 3%, so thus a safe withdrawal rate is 4%.” All of those things depend on a very specific set of assumptions. Those assumptions could be absolutely true or not true at all depending on where you sit in the timeline of history and what the future looks like.

Most people need some sort of a margin of safety relative to these things. I get worried when I see people hit an arbitrary benchmark, like achieving a $1 million balance in their 401(k) plan. This may lead them to think, “I’m done because I can safely take out this rate every year.” People need a margin of safety above and beyond what a basic Monte Carlo simulation would tell them because we never know what the future’s going to look like. Every single developed country has had equity market drawdowns of 75% or more. So, there’s the potential for really bad stuff happening, and we have to be prepared for it. [Editor’s Note: Monte Carlo simulates various scenarios and outcomes by randomly selecting and ordering data up to thousands of times.]

Going onto conservatism, I know it favors the status quo. People are supposed to focus on the long term, but they face short-term risk front and center on a constant basis. So, how do people limit the influence of short-term events?

Well, one of the cool things about conservatism that Nobel laureate Richard Thaler and others have exploited is the status quo. Just as surely as our tendency to do nothing can bite us, it can also help us. Things like locking in auto-withdrawals and auto-escalation are types of conservatism that are very powerful and positive.

Conservatism is a great predictor of whether or not you cross the finish line financially. Think about other tough decisions we make, say decisions around nutrition. If you could lock in every January 1—when you’re feeling motivated—the way that you were going to eat and exercise for the rest of the year, those things would just happen if you did nothing. We’d all be in great shape, right? Yet we do have to make those decisions again and again, and that’s why we’re not in great shape.

The great thing about finances is that you can—in a moment of inspiration, in a moment of clarity of thought—lock in some really great practices and let your natural tendency toward laziness and inertia take over in the best way possible.

I know you have encouraged people to make slower decisions. What is the reason?

One of the things we find is that when people are pressed for time or urgency, they tend to rely on what’s worked historically. This may or may not be the best thing. Something like 80% of people rely on the status quo if they’re forced to make a quick decision, whereas it’s more like 50/50 for people who sleep on it. So, just slowing down a process, just sleeping on it or taking an extra moment to ponder that decision, leads you to think about it more holistically and makes you less likely to rely on the status quo.

You favor systematic approaches. Is there guidance for creating them that you can share?

There’s a lot of conversation about active versus passive investing. And there’s a lot of “haughtiness” around what counts as active and what counts as passive. I want to diffuse this conversation a bit and say: It’s less important whether what you’re doing is nominally active or passive, and it’s more important that it’s low-fee, low-turnover and rules-based. Those things are more important to me than whether something is active or passive.

There’s nothing magical about market-capitalization-weighted passive indexing that leads it to beat so many of its active peers. It’s just that those strategies are not shooting themselves in the foot. The managers of those funds are not falling prey to behavioral errors. I actually think there’s a better way to do it, but it needs to have all three things that the best investment approaches have in common: they’re low-turnover, they’re low-fee and they’re rules-based.

In my prior book, “The Laws of Wealth” (Harriman House, 2016), I looked at a meta-analysis, which is a study of all the studies, on discretionary decision-making versus rules-based decision-making across a number of contexts. It covered over 200 studies. What we found is that simple rules beat investor discretion more than 94% of the time. So, again, the research is pretty clear that rules-based approaches work.

Becoming an Informed Consumer of Investment Media

As news outlets become more and more specialized, the value of information can become so diminished that it’s harmful. What’s more, the coming glut of information means that we will all be compelled to rely more and more heavily on heuristics (mental shortcuts). To help combat this, Crosby suggests the following for evaluating what you hear or read:

Evaluate the Source: Ask whether this individual has the appropriate credentials to speak to this matter or were they chosen for superfluous reasons such as appearance, charisma or bombast?
Question the Melodrama: While volatility can be the enemy of good investing, chaos and uncertainty are a boon to media outlets hungry for clicks and views.
Examine the Tone: Does the report use loaded images or make ad hominem attacks? These are more indicative of an agenda than an actual story.
Consider Motive: News outlets are not charitable organizations and are just as profit-driven as any other business. How might the tenor of this report benefit their needs over yours as a decision-maker?
Check the Facts: Are things being presented consistent with best academic practices and the opinions of other experts in the field? Are facts or opinions being expressed and in what research are they grounded?

Adapted from “The Behavioral Investor” by Daniel Crosby (Harriman House, 2018).

Within that broad umbrella, there’s a million ways you can do it. I think the best investment approaches have the three things in common. I think that they are all based in a sensible theory. So that’s point A. Point B is that there’s data to support the theory. Point C is that there exists some sort of behavioral underpinning as to why the theory persists.

Value investing checks all three boxes. There’s a great theoretical reason why value should work. There’s data to suggest that it’s worked over long periods of time. And there’s a behavioral reason why it endures. It’s really hard to do and it suffers periods of dramatic underperformance like it has been experiencing lately. You could say the same thing about momentum investing.

I’m sort of style-agnostic as long as you have a low-fee, low-turnover and rules-based way to access an edge that is data-driven, theoretically sound and behaviorally grounded.