Ideas

Behavioral Finance Video: The Investor's Greatest Paradox

Investors are faced with a giant paradox:

1. We must invest in risk assets to survive.

2. We are psychologically ill-equipped to invest in risk assets.

Watch this short video to learn how we can begin to resolve this seeming contradiction and make sure that you subscribe via YouTube so as not to miss a single episode of, "On Your Best Behavior."

Practical Tips for Ignoring Investment "Noise"

We live in a noisy world that is getting noisier every day. Faced with an onslaught of information that we are wired to misinterpret, we must develop simple strategies for making sense of it all. A few suggestions include:

Base Camp – Our imperfect memories and insensitivity to base rates means that we are likely to confuse ease of recall with probability. Wherever possible, seek out historical probabilities and rely on them as best guesses for your own course of action. If it takes most people two years to write a book, you’re unlikely to knock one out in three months. If most people should diversify because single stocks are risky – so should you.

Look for the Overlooked - Nassim Nicholas Taleb hilariously relates a story that speaks to how we think about innovation and how our best efforts to be creative can be thwarted by our tendency to overcomplicate things. As Taleb points out, the wheel was created over 6000 years ago, but the wheeled suitcase was not invented until 1970. In fact, humankind even achieved manned space flight (May 5, 1961) before the invention of the wheeled suitcase! Are there simple, elegant solutions that you are overlooking by trying too hard?

Keep it Simple - Just as more information about Linda the bank teller (look up this experiment if you're not familiar!) makes us less capable of judging what really mattered, so much of what passes as investment advice is marketing or clickbait with a thin educational veneer. A part of any sensible approach to security selection is determining what matters most and a focus on those variables to the exclusion of the cacophony all around. True investment signal consistently passes three tests – 1. It is common sensical (i.e., no Bangladeshi butter production) 2. It is research based 3. It endures as a result of a behavioural component.

Check Yourself – One type of information is deserving of extra scrutiny and an added dose of skepticism; information that you are excited to hear. Your excitement about believing something and your incredulity should be inversely proportional to one another.

Two Free Chapters of The Laws of Wealth

My publisher, Harriman House, has graciously agreed to let me distribute the Preface and a sample chapter of The Laws of Wealth to allow you to "try before you buy." The sales and the critical response to the book have exceeded all of my expectations and I'm grateful for this opportunity to continue to spread the word. Please enjoy your free chapters, help spread the word and consider purchasing the book here. Thank you! - DC

Three Mistakes We Make When Setting Financial Goals

The start of the new-year is a time for new beginnings and aspirations of a greater tomorrow. But for most of us resolving to better each January 1, it is the triumph of optimism over experience. A study conducted by the University of Scranton and published in the prestigious Journal of Clinical Psychology found that while 45% of Americans make resolutions each year, a paltry 8% of those goals are actually achieved.

 As one might expect after a holiday full of binging, the most frequently cited resolution is to lose weight. But goals to “spend less, save more” come in at #3 in the University of Scranton study. If you are one of the 34% of Americans that resolved to make better financial decisions in the new-year, here are some pitfalls to avoid:

Pitfall #1 – Your goals are impersonal

 It is a well-trodden corporate truism that “what gets measured gets done.” What is less discussed, however, is that the way in which it gets measured impacts how it gets done. In investment management, market indices should be viewed as what they are, a measure of the performance of an arbitrary smattering of businesses. What index performance should not become is a proxy for your own investment goal setting. Just as surely as you would not presume to use someone else’s weight loss goal as your own, you should not use an external benchmark as a yardstick of your own needs.

 Pitfall #2 – Your goals aren’t meaningful

We spend so much time working to acquire and compound money that we tend to forget one fundamental truth – money is only as good as the personal needs it meets. What surprised me when combing through research to write Personal Benchmark was just how powerful recoupling personal meaning and investment management can be. One of my favorite studies we shared in the book was that low-income savers who put a picture of their children on their savings account more than doubled their propensity to save! By simply pairing what mattered most to them with their financial decision-making, they became more rational overnight.

 And this tendency is not just limited to those with limited means. A large investment house that caters to high net worth investors was well positioned to observe the power of tying to goals to decisions during the crash of 2008. Over half of their clients in traditional platforms exited the market entirely or greatly reduced their equity exposure, effectively selling low. On the other hand, 75% of their clients who had more explicitly tied their personal goals to their investment decisions stuck it out and were well positioned to catch the considerable rise in stocks that ensued. Connecting personal and investment goals is a simple idea that can pay impressive dividends.

 Pitfall #3 – Your goals aren’t in your power

Financial goals should be firmly rooted in behavior, not a desired level of return. The first reason for this is that investors tend to confuse “the return I want” with “the volatility I can stomach.” While behavioral finance has taught us that there is an imperfect correlation between risk and reward, there is a strong relationship nonetheless. 

The second reason is that the vagaries of the marketplace can lead us to feel powerless and ineffectual – a concept formally referred to as “learned helplessness” in the psychology literature. Martin Seligman, who pioneered the research into learned helplessness, found that when we are not in control of the outcome we are trying to influence, we tend to give up. This year, make sure that your goals are tied to behaviors that are 100% in your control rather than a desired market return. You control what you save. You control whether or not you panic. In the short term, the market may or may not cooperate, but in all markets, you control what matters most.

The Best Books on Behavioral Finance and Behavioral Economics

It seems as though I get asked just about every week, "If I want to learn more about behavioral finance, where do I start?" So, in an effort to give a more comprehensive answer to that question (and save myself some time), I've compiled the list below. Happy reading!

The Bible(s):

The Laws of Wealth - Crosby 

Thinking, Fast and Slow - Kahneman

Irrational Exuberance - Shiller

Nudge - Thaler and Sunstein

Antifragile - Taleb

Introduction to Behavioral Finance:

Why Smart People Make Big Money Mistakes - Belsky and Gilovich

The Little Book of Behavioral Finance - Montier 

Predictably Irrational - Ariely 

Misbehaving - Thaler

Animal Spirits - Akerlof and Shiller

History of Finance:

This Time is Different - Reinhart and Rogoff

A Short History of Financial Euphoria - Galbraith

Biology + Psychology + Investing:

The Hour Between Dog and Wolf - Coates 

Goals-Based Investing:

Personal Benchmark - Crosby and Widger

Risk:

Against the Gods - Bernstein

Decision Making:

The Checklist Manifesto - Gawande

The Investor's Paradox - Portnoy

The Paradox of Choice - Schwartz

The Power of Fifty Bits - Nease

Think Twice - Mauboussin

Behavioral Investing:

Quantitative Value - Gray and Carlisle

Behavioral Investment Management - Davies and Servigny

Value Investing - Montier 

Behavioral Portfolio Management - C. Thomas Howard

The Most Important Thing - Marks

The Little Book That Still Beats the Market - Greenblatt

A Wealth of Common Sense - Carlson

Dual Momentum - Antonacci 

What Works on Wall Street - O'Shaughnessy

Contrarian Investment Strategies - Dreman

The Intelligent Investor - Graham 

You Can Be a Stock Market Genius - Greenblatt

A Random Walk Down Wall Street - Malkiel

Probability:

The Signal and the Noise - Silver

Fooled by Randomness - Taleb

The Black Swan - Taleb

The Drunkard's Walk - Mlodinow

Women + Investing:

Women of the Street - Jones 

Warren Buffett Invest Like a Girl: And You Should, Too - Lofton

Best Expose:

Backstage Wall Street - Brown