Intro (1,2) – limiting the unforced errors of investing
Marcus Schafer (00:06)
Welcome back to episode 16 of Greenstream where logic meets life and investing. I’m Mark Schafer along with Pat Collins, your host. We’re with Greenspring Advisors. Last episode, Pat, we talked about investor investment risk, right? Which is, what are the expected returns of investments? ⁓ And today we thought it’d be really good to dive into investor risks, which is…
Can you as an investor actually go out there and capture those investment returns? Episode 13, I think it was, we also talked about that episode was titled, Is My Financial Advisor Worth It? Something like that. And we talked about this 2 % value add from behavioral coaching. And I think your question is like, hey, can we unpack that, help people understand a little bit what is behavioral coaching? I don’t like that term, but what
what actually is going on there. that’s what we try, we’re going to try and do in this episode is unpack that a little bit.
Pat Collins (01:10)
Yeah, there was a few takeaways I had from this episode that I thought maybe are worth mentioning here in the intro. First is that there’s kind of a genetic wiring that we all have that make it more challenging to be a successful investor. And so we unpack that a little bit more, but it goes back thousands and thousands of years about how we evolved as a species and how we try to avoid risk, how we try to get out of scary situations. And
That’s kind of the opposite when you think about investing, which is we have to be willing to kind of confront scary situations. That’s a lot of times when money is made, that’s the old saying of like during a bear market, money is returned to its rightful owners. It’s the idea that the people that can stick with the bad times are the ones that are going to be successful. So we talk a little bit about the genetics. I love the fact that we really get into some of the data and the research around some studies that were done around behavioral kind of biases that can happen with investing.
And then I guess the final thing is hopefully when we wrapped it up, we talked a little bit about, what can you do? So, you know, we recognize that people have all these different biases based on our experiences, based on our genetics, based on just how our brains get wired over time. And what can you do to hopefully counteract some of those things? So at the very end of the podcast, we talk about some of those things you can think about to try to just make yourself a better investor.
Marcus Schafer (02:37)
Sure.
Yeah. Yeah. We use the survey of behavioral finance by Thaler and Barberis. That’s like kind of the pinnacle. That’s the standard. It’s where everybody goes back to. We unpack some of the underlying research that they’re citing. We look through that. I love the stock-ale paradox you ended with. just to me, was, yeah, I could see the correlation. And the last thing I think about, it’s about
Can you capture these investment returns? And I think about a lot of the things we talked about. These are like penalties in sports or unforced errors. And the objective you should try to be learning about, we should try to be learning about too is what are these types of unforced errors? And then how can me as an investor try to limit them to give me the greatest chance of getting out there and winning the game, whatever game it is you’re trying to play. But it’s just a.
really helpful, you know, think about, hey, you do this, it’s just 10 yarn roots. It doesn’t mean you have to quit. It doesn’t mean anything more than the immediate impact. But if you can learn from this, you can get a little bit better. So we’ll just jump into it. This is episode 16 where we’re talking about behavioral finance. What is behavioral finance? Behavioral finance says that people are not rational. Like this is groundbreaking academic research coming alive.
people are not rational, it’s trying to understand under what context are they not rational, are we not rational because we exhibit some of these behaviors too, and then what are the implications for investment markets. So there’s probably two major kind of implications. The first is if people are not behaving rationally, there is potential for there to be limits to arbitrage, which means if you see a disconnect in prices, it’s tougher to get it back towards
their fair value, there might be some implications there. And then the bigger one is what kind of behavioral triggers are holding you back from recognizing the returns that we talked about before that you should expect. So what are some of these? We’re going to just go through and list them out and we’ll probably hit about 10 or 15 of them. So there’s a lot. The first one is overconfidence bias.
Overconfidence (3,4) – can lead to increased trading, which has been shown to lower returns
And this is super well documented in academic literature across fields. Right. And this is just saying that people believe they are better than statistically they could be. So there’s kind of all sorts of different studies. look at, do lawyers think they’re better at lawyering? Do drivers think they’re above average drivers? About 90 % of people tend to think they’re above average, which we know can cannot be true.
So overconfidence, when you overestimate your abilities, creates hurdles to capturing returns.
Pat Collins (05:39)
Maybe ⁓ a humbling story that I’ll tell. The first stock that I ever bought went to zero. I lost all my money. And I think it was a heavy kind of part of this overconfidence. I was in college or just getting out of college. And if you remember this time, this is the late 90s. This was during this, the heyday of kind of the tech boom and everybody was making money.
And I just started watching the stock. didn’t know much about it, but I saw people in my family that had made some money on it. And I thought I could do this too. How hard is this? So I put all of my money into this stock and over the course of maybe a few months, I happened to lose it all. So I think there is an element of course of like overconfidence. One of the things I look back on now though, not only did I lose all my money on that stock,
I then also got into this industry at the very peak of that time and all I knew for three years. So I started in 2000. That was the peak of the market. And for the next three years, the market fell. And so it was kind of like the antidote for overconfidence is every time I bought a stock for either myself or my clients, it went down for three years in a row. And so I do think that personally, I think that made me a better investor.
is wiping away that overconfidence very early on. Every time, it’s like getting punched in the face every day that you woke up for three years. Eventually, you say, I don’t really know if I know what I’m doing here. I think that’s the antidote for overconfidence is you have some failure that it doesn’t work out in your favor. I’ve said before, think one of the things that’s maybe the worst thing that can happen to an investor is they pick a few stocks early on.
as they start investing and they have success with it. Because it leads to this idea of overconfidence, which then can really get you into trouble, as you mentioned, because you don’t really understand or think about the probabilities. You just think, I’m better than everybody else at this.
Marcus Schafer (07:45)
And those probabilities, I think, are super, super important because overconfidence, it leads us to think that the world is narrower than it is. So if you look at like expected returns for the S &P 500 every year, it’s kind of a tight band. And then when you look at the actual data, you see there’s a much wider band and you’ll see that that band is mostly going up. And then you looked at historical and odds are
some years it goes down, like why are people not assuming it goes down? It also really just, you struggle to, I think your example is like a great one of this. Certain things are going to happen less frequently and things you think are impossible are going to happen more likely, like a stop going to zero.
Pat Collins (08:35)
This idea of kind of the things that you think are frequent may not happen as much as you think. I mean, it’s the best example that I know is when you look at the average return of the market and you already look at analysts or whatnot every year, they say, what do think the market’s gonna do this year? They all kind of say, oh, it’s gonna average about 10%. That’s probably a good guess because that’s what the market averages over time.
but it’s so rare that it actually earns 10 % in a given year. I think it’s like about 10 % of the time, it actually earns kind of around 10%. Most of time it’s wildly over or above those figures. So this idea that you’re very confident that, in the beginning of this year, whenever I’m investing in it, it’s gonna earn this. The outcomes are so wide. really, once you really understand the probabilities and the numbers, it’s hard to be overconfident. So I do think
Part of this is experience of just going through it. And sometimes, you know, in this market, if you’re trying to pick stocks, you get very humble very quickly. But the other part is just being a historian and really understanding how the market works. I think that can lead to, you know, kind of being a little bit more humble with how you invest.
Marcus Schafer (09:47)
Absolutely, and I’m always looking to get some elbow patches on my jackets, Pat. Exactly. The last and clear example of overconfidence is they’ve done studies that men trade about 50 % more often than women. And the assumption is when they try to control for more other factors like financial literacy or different things is that men are just more overconfident. Well, what is the implication of that?
It’s about 1 % less returns per year in the data. And this is kind of in the time period that you were talking about. Interestingly enough, we don’t really have too great of data around individual investor performance after some of these studies came out and said that it’s pretty tough to do, but both men and women individually trading underperform the market. But then the men are underperforming by a percent more relative to
to women and a lot of that is attributed to overconfidence bias.
Pat Collins (10:49)
Yeah, that’s unfortunately a sad commentary on our on our side of the gene pool. But but, you know, yes, that’s I think you’re exactly right. So maybe moving on, know one of the other biases that you we’ve talked about is this idea of just optimism and wishful thinking.
Optimism and Wishful Thinking – can lead to taking too much risk
And personally, you know, where I see this happen a lot is investors that come to us that need to make up a lot of ground because they’re behind in their their retirement savings, for example. And so a lot of times you’ll find that there’s this kind of wishful thinking or over optimism that, I’m going to earn 12 percent or 15 percent a year. And I’ve found also a lot of times those same people have a hard time when there’s losses because they have this overconfidence and optimism that things are going to be great.
and that things are going to work out. And when they ultimately don’t and they won’t for some period of time, they have a hard time adjusting to that. just really kind of coming back to understanding that the markets are going to go up and down. You should not have this mindset that the markets are just going up and or that you are going to be smart enough or kind of be able to outperform enough that you can outperform. You you can pick stocks or get in and out of the market.
based on whatever factors that you think. So it’s kind of this idea of just wishful thinking. Are you thinking that you’re better than everybody else? Are you thinking that you’re gonna be able to outperform because of some skill that you have? The data doesn’t suggest that you’re gonna be able to.
Representativeness – future returns aren’t due, like “tails” isn’t due when flipping a coin
Marcus Schafer (12:33)
Yeah, yeah. And that one kind of leads into the optimism of wishful thinking leads into representativeness bias, which there’s kind of two components and one of them is ⁓ you extrapolate a small sample size into thinking it’s a representative of the bigger sample size. So that’s kind of like your example, hey, the last three years have been really, really good. So the fourth year’s going to be good.
Not necessarily. They do come in bunches, but you should be really, really careful about that ⁓ next leap. then there’s also just humans in general have a really, really difficult time understanding probabilities. And that’s what this bias is really about is like, hey, can I understand the differences between one sample and the next?
And it’s just super, super tough to do. The kind of framework that they give to anchor it in psychology is they tell a story about a bank teller and they give all these details. And then they ask you, Hey, is this bank teller more likely? it this or this? And there’s more bank tellers. And the example, by the way, is the bank teller and a feminist. And they give you all these details and it anchors your belief into focusing on
feminism aspect. But then you go out there and you look at the stats and there’s just more bank tellers. So from a pure statistical likelihood, it’s actually more likely that it’s going to be a bank teller.
Pat Collins (14:12)
I told my kids this, I’m a big believer that one of the things that can really help you in life is understanding statistics and probabilities. I feel like in investing, especially, this is an area that people just get wrong, whether that’s because of overconfidence or some of these other cognitive biases that you can have. But the idea that you can understand the probabilities and statistics of outcomes
It can be so helpful in the investment process because what you get to realize is that there are no sure things. There’s a ton of randomness to investing, especially in the short term. And when you start to understand that, can be your confidence can shift from my own abilities to just the overall market doing what it tends to do. And I recognize that when things go up and down, it’s just a normal.
or part of the probabilities of what’s going to happen or the statistical kind of outcomes. And so even when you have really, really crazy events like COVID or the financial crisis or whatnot, that’s all within the realm of statistical probabilities. These aren’t things that are like, my God, this should never happen. So I think that’s really important when you’re thinking about these biases is can you counteract them with a lot of things that you were saying around representatives, this and sample size and you understand that stuff.
because even just some very basic understanding of statistics can really, really help.
Conservatism – not understanding risk might lead to inadvertently taking different risk
Marcus Schafer (15:44)
Absolutely. And the danger, if you kind of don’t understand some of this, is another bias, conservativeness, which is kind of like the opposite of overconfidence. When it’s really tough to understand a problem, you underestimate the likelihood. And that might lead to things like not taking enough, quote, risk. We talked about that last time, right? But hey, if you really need to be getting 7 % per year to outpace inflation and
you’re faced with a challenge that’s tough for you to understand, if you don’t take that risk, there’s a risk that you’re taking inadvertently and that’s kind conservatism bias. It’s just struggling to understand so you lean more conservative in your estimates of the future than you probably should.
Pat Collins (16:31)
I have this great uncle who’s since passed away and he grew up during the depression. He was a kid during the depression. And ⁓ as he grew up, became successful in his career, but I think still had this kind of remembrance of what happened during the depression and the stock market crash and whatnot. And through his life, even though he saved a lot of money, the only thing he ever invested in was T-bills.
And it was this idea that, you know, to your point of this conservatism, he didn’t fully understand. And he had this kind of idea of what the stock market was. It felt like gambling. He didn’t really understand it. So he just took the other extreme approach, which was I’m going to put all my money in T-Bells. So, because I know that that’s guaranteed. And I think about him a lot in that how much money he left on the table. If he, you know, maybe had some more education, understood about this idea of.
probabilities and statistics with the markets, even with a small amount of his money, it could have been life-changing for his family. ⁓ yeah, it’s clearly conservatism. You do see that from time to time when people come in, it could be for a lot of different reasons, but they may really, really not take enough risk, which can be detrimental.
Belief Perseverance – it is hard to change opinions, even in the face of overwhelming evidence
Marcus Schafer (17:49)
Yeah. And the challenging thing to that is
It’s really hard to change your beliefs over time. And that’s another bias, belief perseverance. this is, every time you’re looking at the data, you’re still anchored to your previous assumption, even when the data is overwhelmingly telling you something different, right? So in the great uncle’s case, the data is like very clear, hey, stocks have a higher return than
then T-bills and nothing’s going to persuade it. So it won’t change our opinion. We won’t go searching out of our way to challenge our beliefs. Anytime we are confronted with additional information, we’re going to be skeptical of it. And then sometimes there’s this really weird thing that happens, confirmation bias, where we see some data and it really should change our mind.
It’s pointing in the other direction, but we use it to confirm our prior beliefs. So just weird things kind of happen and it’s just tough to change.
Pat Collins (19:02)
It’s nowhere better seeing this is not on the investment front, but obviously in politics and the news right now, think obviously even I think it’s exacerbated by technology and social media. Understanding what I click on, they’re going to keep feeding me that information. But clearly, we certainly want to watch things or listen to things that confirm our previously held beliefs. know this probably about a year or two ago, I was on vacation and sitting at the pool at this resort and this
Guy turned to me, we were chatting about something and he said, what do do for a living? And I told him, ⁓ I immediately regretted what I said because he just wanted to dive into crypto and talk about Bitcoin and these other cryptocurrencies and how great it was going to be. And I sat there after a while and kind of got done. I finally got out of this conversation. anybody’s talked to somebody that’s like really like big on crypto, sometimes it can be a little exhausting. But I realized a couple of things. One is.
I was never going to change this guy’s opinion, but I also have my own confirmation kind of belief perseverance here that I had a kind of a previously held belief that would like, I wasn’t listening to the other side of it. So I do think that there is this, it’s really hard to do, but whether it be for investing or other areas of your life, think waking up every morning with kind of the mindset of I could be wrong is so beneficial when it comes to investing.
I’m not saying that you should just be trying everything, but you should be willing to challenge your beliefs and listen to the other side of it. Because oftentimes we’re so entrenched in our own beliefs that we’re just not even going to listen. Or when we do listen to something, we are trying to find things that will confirm our beliefs and not listen to things that might challenge those beliefs. So I’m not really sure how you do it other than to just really try to think like,
Could I be wrong? I could be wrong about this. And let me just hear the other side again. So anyways, I just think it’s important thing to kind of try to keep that mindset when you’re investing. It’s really, really important.
Marcus Schafer (21:10)
Yeah, and the higher level your beliefs are, right, in terms of first principles, the easier I think it is to understand different arguments as opposed to you get all the way down in the implementation, right? And you think about what are the actual beliefs being held. Those are much tougher to change. But if you go out there and you have a higher level framework like crypto and you’re saying, hey, does it have a market cap? Do other people value it? Like, okay, that tells me it’s not.
completely made up, right? Like people are trading it, the price is going up, the price is going down. I might have a differing opinion about what that means for my portfolio, but it’s a $3 trillion market cap. So it’s not like it’s completely, completely made up. The next bias I want to jump to Pat is anchoring bias. And anchoring bias is super common in negotiations.
Anchoring – often present with setting price targets despite prices always changing due to new information
But it’s, kind of have this set arbitrary expectation of what something is. And oftentimes, by the way, it’s completely arbitrary. It could just be, Hey, I think expected returns are 10%. Do you know they’re 10 %? No, you just kind of pick that. But the challenge is when you’re confronted with new information, you don’t adjust that arbitrary anchoring to something a little more realistic.
Pat Collins (22:37)
I’ve seen this when I’ve talked to some friends, not necessarily clients I don’t see this as much with, but with those that like to trade a bit. And I remember this one conversation I had with a friend of mine who basically said, know, my strategy with this stock is every time it hits 50, I sell it because it always goes down once it hits 50. And then I repurchase it when it hits 40.
and it like trades in this range. And so he was just anchoring on this price of like $50 is the capital that it always sells off at 50. And I repurchase at 40 and I can make money that like, you know, basically it’s like a money printing machine. And I just chuckled because, you know, he obviously was looking at a chart and maybe did this a couple of times, but that never works long term. But he was just anchoring on these, this price of where to buy and where to sell because of a chart.
Basically. So a lot of times you’ll see that. I feel like I see that sometimes with people that are doing like technical analysis, looking at charts saying, oh, this is the price that once it exceeds this, then, you I’m going to buy or sell it, that kind of thing.
Availability Bias – recent and severe events change our expectations, but not the data
Marcus Schafer (23:46)
And maybe that could be a component of this next bias, availability bias, which is essentially saying,
What frames your expectations about the future is more recent and more severe events, right? So, you hear a lot of people talking about pandemics. Right now, hey, maybe there’s a potential next pandemic. Well, it’s no shocker that it came on the back of a really recent and severe events in relation to your example. Hey, y’all, if you buy it at 40 and it goes to 50 and you sell it,
And they say, I’ll buy back at 40 again and it drops to 40 and you do it again, you’re kind of like, hey, maybe there’s something to this, right? And so that’s availability bias that’s kind of anchoring right in there.
Ambiguity – it’s a part of our evolution, the benefits just don’t translate into investments
Pat Collins (24:38)
Absolutely. Yeah. So there were a few other areas that we wanted to touch on when it came to, you know, kind of investor beliefs. But before we get into that, you know, it just kind of it strikes me that. A lot of this stuff we’re talking about, it comes from like our brain, basically, and some of the tricks that our brain can play on us. And I think this is why I believe investing is so hard is.
that we have like thousands and thousands of years of kind of evolution that probably are working against us to a degree. know, our ancestors, you know, they kind of really honed in on this fight or flight syndrome. So if I was out on the, you know, out in the ⁓ prairie and a lion comes up to me, our ancestors that stood up and said, let’s fight this thing.
they’re not around anymore. They didn’t make it. The ones that made it were the ones that said, let’s get out of here. And so I think as humans, we’ve had this long condition of really trying to avoid pain, kind of when we see it, when we’re afraid, we try to get out of that situation. And that’s served us really, really well in relationships and evolution and lots of different things. It’s so counterintuitive for investing where you have to stand there and take the pain.
And most people have a hard time with it. That’s why all these cognitive biases, a lot of them are kind of shortcuts that our brains created to help us survive over, over time. And it’s the exact things that make us really, really sometimes our own worst enemy when it comes to investing. So a lot of times just our initial instincts, those of us that deal with our guts, a lot of time, it can be really, really detrimental when it comes to investment performance, because it kind of forces us to some degree or makes us.
do things that are kind of in contrast to what the best decision would be based on the probabilities.
Marcus Schafer (26:38)
Yeah, a lot of it, to your point, there are shortcuts. It’s pattern recognition. We developed over tens of thousands of years to try to understand a really complex world. The challenge, just doesn’t really translate into numbers and uncertainty and unknown. And some of the systems break down and it’s not really anybody’s… I wouldn’t say it’s a fault. These are just traps you have to try to be aware of.
And if you’re aware of them, you could try to limit them.
Pat Collins (27:08)
The last thing I’ll mention on that, and this is just, it seems to be a theme of the podcast, so I’m just gonna bring it up again, because I think it’s such an important concept. And it’s the idea of divorcing your decisions with the results that you get. And it is a really, really hard thing to understand or kind of intuitively make sense with the idea that I can make a great decision and get a bad outcome.
When you are dealing with randomness and some, you know, it went with anything, you can make good decisions based on probabilities and statistics and get a bad outcome. So, you know, I’m not, I’m not a huge gambler, but I can go to the casino, play blackjack. get dealt two aces and the dealer showing a five. The best decision I can make is to split those aces. I can lose both hands. I can lose both of those, you know, those aces that I split, ⁓ because I just have a bad outcome.
It doesn’t mean I made a bad decision. I always have the right decision. And if I do that over time, it’s going to work out in my favor. But the problem is, is that sometimes people look and say, I made a bad decision because I lost or I made a bad decision because I bought this, this index fund. And a year later, it’s down 20%. It probably wasn’t a bad decision. mean, obviously there’s lots of factors there, but it was probably a good decision. It’s just, it’s just a bad outcome.
And so once you kind of start to learn probabilities, you realize I’m going to get some bad outcomes sometimes. That’s okay. know if I do this right over, you know, make the right decisions over a long period of time, then I’m going to have over the long term, a very good outcome. This, know, using kind of the gambling mentality, it’s, it’s almost like trying to turn yourself into the house instead of being a gambler. So if you are making good decisions, just like the casino knows,
If I can get people to play long enough, we’re going to win. And the same thing is if I can make good decisions over a long enough period of time, I’m going to win. And so just making sure you understand those probabilities are so important. I feel like in trying to counteract some of these cognitive biases that we can have.
Prospect Theory – people hate losses more than we like gains
Marcus Schafer (29:21)
Yeah, and understanding those probabilities, there’s kind of this second degree. So we talked about beliefs and then there’s preferences, economists were always talking about tastes and preferences. But there’s a preference people have when it comes to gambling. Like if I don’t know the probabilities, this is the ambiguity aversion, I’m less likely to want to participate in that gamble. So if I don’t know the probabilities,
I’m less likely to participate. That’s a big one. Another one you mentioned is prospect theory. This is probably one of the biggest components that researchers are really focused on. And prospect theory kind of goes back to what I said last time. What is risk? It’s pain when I’m in pain. People really do not like losses relative to how much they like gains. Your next incremental gain
is not that much more significant. But if an incremental loss hits you, it’s way more significant on your behavior and your willingness to participate. And so this prospect theory, this is a lot of ⁓ one of the behavioral expectations for why stocks have such higher expected returns than bonds because we don’t like the chance that we might lose some money. And it’s kind of like the way I would express it in
terms of probability if you take something that’s 20 % likely and go up to 50%, that’s a 30 % jump increase there. People are pretty pumped up about that. But then if you take that same percent increase and go from 70 to 100%, people are not as excited on a relative basis. So I think there’s that prospect theory which
and ⁓ ambiguity aversion, which kind of just covered.
Pat Collins (31:18)
Cross-Spec theory, just say one thing on that. I’ve seen all the research on it and how people want to avoid losses more. They hate losses more, they enjoy gains basically. Just anecdotally, when the market falls, we get a whole lot more calls that come in from really, really concerned clients than when the market’s going up for people calling us saying, wow, this is great, or let’s buy more or anything like that.
I agree that losses really impact people more than gains, at least in their minds, obviously. But I think it’s a really good point. And knowing yourself to say, okay, am I making this because I just really, really hate losses? Am I making this decision? Is it rooted in probabilities and evidence and what’s the likely next outcome kind of thing? anyways, it’s important to make sure, hopefully, if you can stop and maybe check yourself and
You know, you’re hearing all these different things that we’re going through is, this, is this maybe a bias that I have in this example of, just hate losses. Well, why is that? What is the, you know, what’s the root of that? And is there a way for me to kind of trick myself almost into saying, okay, there’s going to be gains coming. Can I, can I hold on?
Insufficient Diversification – familiarity is the opposite of ambiguity
Marcus Schafer (32:37)
It builds into kind of like what we talked about. It’s, they flow really nicely into one another where it’s kind of like, Hey, I could see how this might also implicate this. And the job of the researchers to try and distill them into their most basic components and separate them. But then when you bubble them up, you’re kind of like, Hey, there’s maybe a few at play. So what the researchers have tried to do is try and take
things that are very clear from an academic research perspective, and then ask questions around, why do we maybe not see that from investor behavior? So let’s just walk through some of those examples to try and bring some of these ideas to life. I would say the first one is what the researchers call insufficient diversification. But what this really means is, when you and I are talking about diversification, we’re kind of like, you probably want to buy everything. Let’s start with the market.
And then we’ll deviate from there. so the research kind of bears that out. And the question is, why do people not do that? And there’s just a host of other biases. You kind of see like,
This home bias, right? People tend to own more of their own country.
because they’re familiar with it. Familiarity is the opposite of ambiguity. In my previous role, we worked with advisors all across the world and you would see a home buyers in every single one of them. By the way, the math kind of has to work out. If US investors hold more of the US, other investors can also hold more of the US. But in the US, since we are a big part of the market, people are relatively, they don’t think it’s as big of a deal, but
When we would go out to Australia, that’s about 2 % of the market. And they’re happy if they’re getting their clients that only own 50 % of Australian stocks. By the way, Australia hasn’t had a recession in like 35 years. Just through some weird things, they kind of were hedged against a few of these big turmoils. They didn’t have exposure to those sectors. So people are just more comfortable.
And that’s a crazy overweight. you go back to our last conversation, we’re kind of, hey, what’s your bet relative to the market cap weight? And if the best you can do is 25 times the market cap weight, that’s a pretty aggressive bet.
Pat Collins (35:07)
this idea of insufficient, insufficient diversification. I almost think it kind of stems sometimes to what we teach our kids early on in personal finance, which is very limited, by the way, there’s not a ton going on right now with in the school system with personal finance and having two kids that recently went through high school and graduated and seeing what they were doing for personal finance. two areas that
I see that I think really hurt in practice, like how people think about this. One is when people are just starting investing, what’s one of the main things I tend to hear from parents and other types of people that are counseling their kids? Invest in what you know. That’s the thing that I hear all the time. Well, just invest in what you know. I’m going to give my son $1,000 to invest, my daughter, that’s money to invest. What should I invest? Invest in what you know. So they pick a couple of stocks.
It doesn’t. You know, it’s obviously insufficient, insufficient diversification. We’re training our kids to just invest in what they know. So they’re investing in Apple and they’re investing in Amazon and they’re investing in, you know, whatever Facebook. But are they investing in small cap Japanese stocks? No, because they have no idea what that is. So I think that’s a detriment. The other is the number one thing that they do in these personal finance classes. Both of my boys did it is the stock market game.
And, you know, when you look at the objective of this game, it is they give you fake portfolio of whatever it was. I think it was a hundred thousand dollars. say whoever makes the most money wins basically at the end of the semester. And so all of these kids are basically they’re not dumb. They figured it out. Like my son invested in a Chinese, you know, electric car company that was like they had no revenue basically. And ⁓
You know, they killed it for a while and then they lost like half their money. So it’s, it’s one of these things where I think for the very beginning, our investment education is not preaching kind of diversification, you know, being across countries and sectors and different markets and size and whatnot. We’re telling our children invest in what you know. And then, you know, the only other way that they’ve been introduced to the stock market is through some, basically a gambling exercise. So I understand that.
You want to get people interested and there’s some value to that. But I think as a society, you know, thinking about how we train or educate our children and young investors on how to get into the markets probably has to change a bit because I think it can lead to some of these biases and kind of what happens in practice. And, you know, like I said, God forbid they have some success with it. When my son was having some success for like a month,
He said to me, like, should put real money into this. And I thought, my gosh, like he’s really, you know, has no idea what he’s doing here, but he was overconfident. anyways.
Marcus Schafer (38:12)
And a lot of this is.
You don’t know what you don’t know. And some of the experts out there also, in my opinion, make some crazy statements about diversification. Like one stock per sector, 25 to 30 large cap stocks we talked about this last time, like that’s diversified. And then you just go and pack the research and you’re like, okay, I could see maybe some of your biases at play. But when I’m looking at the research, that’s not
the appropriate amount of diversification. I kind of alluded to this a little bit earlier around overconfidence, but excessive trading is a really big one. One of the things, know, money’s like a bar of soap. The more you touch it, the less you have, right? So excessive trading is a big ⁓ hurdle towards future success as well.
Excessive Trading (5) – money is like a bar of soap, the more you touch it the less you have
Pat Collins (39:09)
I love that analogy, by the way. ⁓ I think it’s just, it’s so true. There was this study that this kind of floating out there that I just think is on, excessive trading. And then it probably could apply to overconfidence and a number of other things that we’ve talked about. Fidelity, who’s obviously got a tremendous amount of data of, of all their client accounts, basically. They looked at two sample sizes. are two samples of investors.
and in their 401k plans. So they’re obviously one of the largest kind of providers of 401k plans. They have a lot of data on the participants, what they’re doing in their accounts. And this was in 2014. They looked at the prior 10 years, so 2003 to 2013. And they found that the investors that were doing excessive trading had worse returns than another sample that they looked at.
And this is kind of comical, but the sample, the other sample they looked at were people that were deceased. So these people passed away. Their beneficiaries didn’t know how to log in. So these accounts were kind of dormant accounts and they found that these accounts had better returns than the people that actually were logging in, placing trades. And so it just kind of goes back to, it’s kind of a funny example of, you know, you don’t have to die to become a good investor, but
The idea of if you are trading a lot and doing excessive trading, it’s probably hurting your chances of having better returns than if you just pick a really good portfolio and don’t touch it.
Marcus Schafer (40:45)
The best research where we could see some of this retail investor behavior and they look at kind of the high turnover, the people that trade the most versus the people that trade the least. Again, a little skeptical because you need the data from the big brokerages. And after some of these studies, you stop, see the data come out. It’s a little bit outside the US. You can see some of it. There’s just different systems and different transparency, but 7 % was the difference between
the group that trades the most and the group that trades the least in terms return per year. And this was in a pretty aggressive market. So the difference was like 18 versus 11 % per year over a few years. But man, that’s a huge hurdle. And it leads into these other different aspects that I think a lot of individual investors might not appreciate. And the next one is
Disposition Effect (6) – sell your winners is bad tax advice
Kind of decisions around selling, there’s this bias, the disposition effect. But it’s kind of like, you want to sell your winners, but you’re going to hold on to your losers. And if you take a framework like us, we’re kind of thinking about the whole picture and we’re incorporating taxes from a tax decision, that’s kind of an insane thing. You’re saying I’m going to pay taxes, but I couldn’t get a tax benefit and I don’t want that.
So if you were to think about the opposite where it’s like, well, let’s say you could sell some winter, but also sell some losers to offset your taxes. so even you’re creating artificial tax drag, which is kind of a hold back, but yeah, a ton of investors sell your winners, right? Common phrase you hear out there.
Pat Collins (42:33)
You mentioned before that a lot of these biases kind of like work together in some ways that kind of like weaving in and out. like, in some ways I hear somebody say, well, I bought that for $50 a share and it’s worth 20 now. So I’m not going to sell it. I’ve got a loss. So they’re anchoring on that $50. So it kind of comes, some of this can come back to anchoring. It certainly is tough. And I think about the study that we cited, I think in a few different episodes from, ⁓
Professor Bessembinder from Arizona State, where he looked at the actual returns of stocks. And there’s a large percentage of stocks that go to zero. So if you bought something for 50 and it went to 20 and you’re thinking, well, it’s got to come back. I bought it for 50. It doesn’t have to come back. There’s a lot of stocks that go from 20 to zero, basically. So, you know, this idea of anchoring or not wanting to take losses because you think it’s going to come back or you just don’t want to kind of realize that loss.
Again, look at the probabilities, look at the statistics. doesn’t mean, especially when you buy an individual stock, it doesn’t mean just because you bought it at 50, the market doesn’t care. It’s going to go to where it’s going to go and probably its past performance is not going to dictate what the future looks like.
Marcus Schafer (43:47)
The other thing you build on with buying that I think is super, super challenging, there must be some biases because if you look at as diversified as you could be, could own about 14 or 15,000 stocks across the globe. That’s probably max based upon the vehicles out there. If you’re only buying five, how’d you get to those five? There’s no way you can look at all 14,000, 15,000.
So there must be something that’s helping you filter down. And the question is, what’s the likelihood that you were able to do that filtering? You were able to evaluate all the opportunities, figure out which securities were mispriced, go out there, purchase those, avoid the other 13,995 that were fairly priced. you know, all this stuff kind of builds to like,
How Can We Limit the Effect of Our Biases? – humility, learning through experiences, and find your community
what can you do about some of these biases and sometimes there’s simple answers and sometimes there’s hard answers. But I guess I’d ask you, you look at this, there’s a bunch of traps. What should you?
Pat Collins (44:56)
mentioned this early on, and I know we have some things that we want to kind of go through that are hopefully like just like checkpoints for people. And maybe these are some things you can think about to kind of check yourself on some of these biases. But the number one thing I think you can do is just have us, you know, try to become more humble in your investing kind of experience. So recognizing that you don’t know. I think about the movie book
Moneyball, which is such a great movie. It’s a great movie about baseball, but it has so much correlation to investing. And, you know, there’s this scene where the general manager is talking to the head scout and he basically says the head scout is saying to the general manager, you’re not taking into account all my experience and all the things that I know and how smart I am. And the general manager says to him.
I’ve been in all these meetings that you have with these prospects and you say, you know, when I know, I know, and I know that you are going to be a great player. And the general manager says, you don’t, you don’t know. And there’s this humbleness that comes with that. And I think it’s the same way with investing. It’s like, you don’t know what’s going to happen over the next year. And when you take that approach and you realize, okay, I don’t, and I realize that, but I understand the probabilities and understand if I have time that the probabilities get better.
I’m going to take that approach. think that’s just such a key thing is being humble is, and I don’t know how to, you know, you could say that I don’t know how to actually do it, but I think part of it is, you know, the whole thing that I said before is if you get punched in the face a few times, you start to get more humble when you invest. I think that’s a big part of it.
Marcus Schafer (46:38)
You have to have that mindset. That’s, you know, I think humility is one, but you have to be able to learn through repetition. This is how we learn. So in your experience, you got punched in the head three times. What did you do? You evaluated and you tried to take a fresh look at the data and your conclusion was maybe I should be more diversified. You could have came to a different conclusion, which is maybe I don’t want to play this game.
at all. You just jump into a different bias. So trying to think about learning through repetition. When I think about what institutional processes look like for offhand conversations with people, how they pay stocks. Hey, did you record? In the institutional space, there’s a deal memo. You designate, hey, here was why I made this decision. Here were the factors. Here’s my understanding at the time.
And they do that so they can go back and look at that decision and figure out, it a good decision? Was it a bad decision? But they can anchor on the decision. Whereas there’s less accountability, there’s less weighing of opportunity costs. So I think you just have to be purposeful around how you’re trying to learn through repetition. Anybody listening to this, I think it’s crazy. People want to listen to us for 45 minutes, talk about probabilities and biases, but
you’re becoming a better investor through it. So that’s another thing is try to find some people that are a little more knowledgeable of different areas than you and try to absorb them. But also you got to have some, have some principles you fall back on.
Pat Collins (48:20)
Yeah, I think this idea of finding people that can help you, this idea of experts or consultants or whatnot. I do think there’s like two elements to this that are worth noting. One is there could be people that just have more knowledge than you do and can help guide you through this, which is going to be helpful. I think there’s another element when we get into the cognitive biases, the emotional kind of issues to it is that oftentimes a third party.
is not as emotionally invested in this as you are. It doesn’t mean that they don’t care. It just means that it’s not their money. So they’re gonna maybe make decisions that are more rational sometimes because they don’t have that same emotional tie that all these different biases, they could still have some biases for sure. And they should be checking those too, but it may be a little bit different. So it’s just something to think about whether it’s an advisor, which that’s kind of how we serve, but it doesn’t have to be an advisor. It can be somebody else that you just talk to before you make
an investment decision and say, just, Hey, can you just check me on this? I’m thinking about, you know, changing my asset allocation from 70 % stocks down to 40 % stocks, because I’m really scared about what’s coming. If you have somebody that’s really smart that you can bounce that off of, and they can understand why you’re doing that. And are you making it, you’re doing, making that decision because you’re scared or you’re making that decision because your circumstances have changed. That, that’ll be helpful, I think. So just having somebody to talk to and
that’s not you and it’s not their money, I think that’s really helpful.
Marcus Schafer (49:50)
Hopefully when you see these different tools at play, it helps you evaluate who can be better positioned to give you advice. You you think about Reddit, a lot of people go to advice there. There’s like two components of Reddit. There’s WallStreet, that’s where probably everything we talked about, they’re like, you guys are idiots. You’re missing the opportunity. You’re not smart.
The Stockdale Paradox (7) – unwavering faith you will prevail, while confronting challenges of reality
And then there’s the bobbleheads, which is much more aligned with the way we’re talking about. And so you just have to think about
Hey, which group do I really believe has my best interests at heart? Who do I align with? Where does the evidence lie? And then, know, over time, tilt towards those groups. Learn from opportunities and mistakes. And by the way, this is not like a, when I say mistakes, think it makes it seem like all or nothing. It’s more like a penalty in sports. Doesn’t mean you can’t win the game. It just means you kind of have a different hurdle.
Pat Collins (50:50)
I like that analogy. Yeah. As we wrap up here, one of the things that struck me as I was thinking about this was one of my favorite books is a book written by Jim Collins, at least business book, called Good to Great. And he looked at all of these great companies and what made these companies great. And there’s several principles that the leaders tended to kind of display. And one of them was this idea of the Stockdale Paradox.
And what that means is basically that hopefully this analogy will make sense for people when it comes to investing. But Admiral Stockdale was a POW in Vietnam and the paradox after he got out, he talked to kind of some interviewers and Jim Collins was one of the people that interviewed him. And basically what he said was, you know, Jim Collins asked him, how did you get through it? How did you get through years and years of captivity and horrible conditions?
And he said, I really had kind of two beliefs on one hand, at the very long-term, had this belief that everything was going to be okay, that I was going to make it. But at the same token, I dealt with the harsh realities of what was happening today. And I realized like this, I’m going through this, it’s really hard and it’s, and it’s challenging. said, the people that didn’t make it were the optimists. They were the ones that just kept saying, it’s going to be, we’re going to go home by Christmas.
And then when it ended at Christmas, we’re going to be home by next summer. And eventually they gave up. And I think there’s a huge parallel with investing is that and some of this comes back to our biases. But as an investor, I do believe you need to have some North Star belief that everything is going to be OK or whatever that belief is for you. And for us, it’s that we believe that over time, the markets are going to go up.
And it’s a very simple belief. We believe that humans want to get better, that there is a profit incentive, that people want to make the world a better place. And therefore wealth is created because of that, because people innovate. make new technologies. They make things better and it creates wealth for people over time. So we have this strong belief on the one hand. Then on the other side, we are recognizing the kind of the turmoil on the ground every day that we believe, even though we believe that.
We also know that there’s going to be horrific periods that we’re going to go through. And I think you can, if you can hold both of those kinds of beliefs and believe them both, I just think that you’re going to be in better place because the flip side kind of going back to that analogy is if I have this belief that everything’s going to be good and I don’t recognize that there’s going to be horrible periods coming up that I’m probably going to.
do some of these behavioral things that make my returns much worse than they would otherwise be. So I think that’s another element of like, how can we counteract that is just have this kind of contrasting viewpoint that things are going to be good in the long-term, but I also recognize that we’re going to go through some bad stretches and that’s okay. Both of those things can exist at the same time.
Marcus Schafer (54:03)
What a great way to wrap the episode. Thanks, Pat.
Pat Collins (54:06)
Thank you.
Sources:
1 Are Financial Advisors Worth Their Fee? | Greenstream #13 https://youtu.be/Is7N5M4e4Ck 1
2 Investment Risk Explained: How Much Diversification Do You Need? | Greenstream #15 https://youtu.be/yEqRrXDAe7A
3 Barberis, Nicholas and Thaler, Richard H., A Survey of Behavioral Finance (2002). https://ssrn.com/abstract=327880
4 Barber, Brad M. and Odean, Terrance, Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment (1998). https://ssrn.com/abstract=139415
5 Barber, Brad M. and Odean, Terrance, Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. https://ssrn.com/abstract=219228
6 Collins, Jim, The Stockdale Paradox. https://www.jimcollins.com/concepts/Stockdale-Concept.html
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