The following is an excerpt from “The Laws of Wealth: Psychology and the Secret to Investing Success” (Harriman House, 2016). Daniel Crosby, Ph.D., is a psychologist, behavioral finance expert and asset manager.
Suppose I ask you what you will be doing in five minutes. Odds are, you will be able to answer that question with a high degree of certainty. After all, it will probably look a bit like what you are doing at the time you are asked.
Now, let's move the goalposts back a bit and imagine that I ask what you will be doing five weeks from now. It will certainly be exponentially harder to pinpoint, but your calendar may give some clues as to how you will be engaged at that time. Now imagine you were asked to forecast your actions five months, five years or even 50 years from now. Darn near impossible, right? Of course it is, because in our quotidian existence, the present is far more knowable than the distant future.
What complicates investing is that the exact reverse is true. We have no idea what will happen today, very little notion of what next week holds and a slight inkling as to potential one-year returns. But we could make a much more accurate estimate of 25 years from now. Consider the long-term performance of stocks by holding periods, as shown in the following table.
|Holding period||Best return||Worst return|
Over short periods of time, returns are nearly unknowable. Over a single year, the range of returns is very wide, from a 54% gain to a 43% loss. Over 25 years, a time period more reflective of a long-term investment horizon, the future becomes far more certain as the range of returns is narrower. Returns vary from a gain of 15% per year to a worst case of around 6% per year for this longer period.
The range of returns is not so scary over the long term, which suggests that stocks ought to be held for the long term. For people, this requires a fundamental rethinking of reality, something that seems not to be happening. As statistician extraordinaire Nate Silver says in “The Signal and the Noise” [Penguin Books, 2015]:
—The Laws of Wealth: Psychology and the Secret to Investing Success” (Harriman House, 2016). Daniel Crosby, Ph.D
“In the 1950s, the average share of common stock in an American company was held for about six years before being traded — consistent with the idea that stocks are a long-term investment. By the 2000s, the velocity of trading had increased roughly twelvefold. Instead of being held for six years, the same share of stock was traded after just six months. The trend shows few signs of abating: Stock market volumes have been doubling once every four or five years.”
Intuition tells us that now is more knowable than tomorrow, but Wall Street Bizarro World, or WSBW, says otherwise. As Mr. Silver points out, more access to data and the disintermediary effects of technology make our human tendency toward short-termism even greater.
This presents an opportunity for those who can deny this tendency; the growing impatience of the masses only serves to benefit the savvy investor. As Ben Carlson says in “A Wealth of Common Sense” [Bloomberg Press, 2015]: “Individuals have to understand that no matter what innovations we see in the financial industry, patience will always be the great equalizer in financial markets. There's no way to arbitrage good behavior over a long time horizon. In fact, one of the biggest advantages individuals have over the pros is the ability to be patient.”
Imagine a world where you could gain more knowledge by reading fewer books, see more of the world by minimizing travel and get more fit by doing less exercise. Certainly, a world where doing less gets you more is highly inconsistent with much of our lived experience, but is just the way WSBW operates. If we are to learn to live in WSBW (and we must, if only to keep pace with inflation), one of the primary lessons to be learned is to do less than we think we should.
The psychobabble term for the tendency toward dramatic effort in the face of high stakes is action bias. Some of the most interesting research into action bias comes to us from the wild world of sports — soccer in particular. A group of researchers ex-amined the behavior of soccer goalies when faced with stopping a penalty kick. By examining 311 kicks, they found that goalies dove dramatically to the right or left side of the goal 94% of the time. The kicks themselves, however, were divided roughly equally, with a third going left, a third right and a third near the middle. This being the case, they found that goalies that stayed in the center of the goal had a 60% chance of stopping the ball; far greater than the odds of going left or right.
MIND OF A GOALIE
So why is it that goalies are given to dramatics when relative laziness is the most sound strategy? The answer becomes more apparent when we put ourselves into the mind of the goalie (especially those who live in countries where failure on the pitch is punishable by death). When the game and national integrity are on the line, you want to look as though you are giving a heroic effort, probabilities be damned! You want to give your all, to “leave it all on the field” in sport-speak, and staying centered has the decided visual impact of stunned complacency. Similarly, investors tasked with preserving and growing their hard-earned wealth do not want to sit idly by in periods of distress, even if the research shows that this is typically the best course of action.
“Never underestimate the power of doing nothing.”— Winnie the Pooh
A team at Fidelity set out to examine the behaviors of their best-performing accounts in an effort to isolate the behaviors of truly exceptional investors. What they found may shock you. When they contacted the owners of the best performing accounts, the common thread tended to be that they had forgotten about the account altogether. So much for isolating the complex behavioral traits of skilled investors! It would seem that forgetfulness might be the greatest gift at an investor's disposal.
Another fund behemoth, Vanguard, also examined the performance of accounts that had made no changes versus those that had made tweaks. Sure enough, they found that the “no change” condition handily outperformed the tinkerers. Further, Meir Statman [ in his book “What Investors Really Want” (McGraw-Hill Education, 2010)] cites research from Sweden showing that the heaviest traders lose 4% of their account value each year to trading costs and poor timing. These results are consistent across the globe: Across 19 major stock exchanges, investors who made frequent changes trailed buy-and-hold investors by 1.5 percentage points per year.
(Related read: What investors really want, need)
Perhaps the best-known study on the damaging effects of action bias also provides insight into gender-linked tendencies in trading behavior. Terrance Odean and Brad Barber, two of the fathers of behavioral finance, looked at the individual accounts of a large discount broker and found something that surprised them at the time.
The men in the study traded 45% more than the women, with single men out-trading their female counterparts by an incredible 67%. Mr. Barber and Mr. Odean attributed this greater activity to overconfidence, but whatever its psychological roots, it consistently degraded returns. As a result of overactivity, the average man in the study underperformed the average woman by 1.4 percentage points per year. Worse still, single men lagged single women by 2.3% — an incredible drag when compounded over an investment lifetime.
GIRLS VERSUS BOYS
The tendency of women to outperform is not only seen in retail investors. Female hedge fund managers have consistently and soundly thumped their male colleagues, owing largely to the patience discussed above. As LouAnn Lofton of Motley Fool reports [in “Warren Buffett Invests Like a Girl: And Why You Should, Too” (HarperBusiness, 2012)]: “Funds managed by women have, since inception, returned an average 9.06%, compared to just 5.82% averaged by a weighted index of other hedge funds. As if that outperformance weren't impressive enough, the group also found that during the financial panic of 2008, these women-managed funds weren't hurt nearly as severely as the rest of the hedge fund universe, with the funds dropping 9.61% compared to the 19.03% suffered by other funds.”
Boys, it would seem, will be hyperactive boys, but few could have guessed the steep financial cost of action bias.
FAR FROM MADDING CROWD
I travel roughly once a week to conferences where, in addition to eating overcooked chicken, I am typically asked to speak to financial advisers about the rudiments of behavioral finance. As anyone who travels for business well knows, it can be tricky in a new city to determine where best to eat, sleep or watch a show. And while many nice hotels provide a concierge to guide you, the concierge's advice is ultimately limited by the fact that it is just one person's opinion.
(Advisers' Bookshelf: Brace yourself for the new world order)
“Far from idleness being the root of all evil, it is rather the only true good.”— Soren Kierkegaard
Having been steered amiss more than once by a concierge with a palate less sophisticated than my own (for surely it could not have been my taste that was in question), I quickly learned to harness the power of the crowd-sourced review. Apps like Yelp, Urban Spoon and Rotten Tomatoes provide aggregated reviews that guide diners and moviegoers to restaurants and films that have received consensus acclaim. While I may not always agree with the taste of an individual concierge or my local newspaper's movie reviewer, I have never been disappointed with a movie or dish that has received widespread approval. In things that matter most (e.g., food and movies), there is wisdom in the crowd.
But the power of crowd thinking is not limited to picking out a tasty schnitzel or deciding whether to watch “Dude, Where's My Car?” (18% on Rotten Tomatoes) — it is the bedrock upon which the most successful political systems are built. Sir Winston Churchill famously opined, “The best argument against democracy is a five-minute conversation with the average voter,” which is a sentiment heard in many forms at election time. So why then has democracy proven to be so successful (or at least not entirely unsuccessful) over long periods of time? Why is it, paraphrasing Churchill again, “The worst form of government, except for all those other forms that have been tried from time to time”?
The answer is in the tendency of the crowd to be more wise, ethical, tolerant and gracious than the sum of its parts. The alternatives, political systems like oligarchy and monarchy, live and die with the strengths or weaknesses of the few, which is a much higher risk/ reward proposition than democracy. The average voter may be unimpressive, but the average of the averages tends to be the best game in town.
If crowd wisdom can help us solve complex decisional problems and provides us with good-enough government, it seems intuitive that it has something to offer investors, right? Wrong. Once again, the rules of WSBW turn conventional logic on its head and require us to operate from a different set of assumptions — ones that privilege rules-based individual behavior over the wisdom of the crowd.
Why is it that a qualitative gap exists between investment and culinary decisions? Richard Thaler, behavioral economist par excellence, has identified four qualities that make appropriate decision-making in any field difficult. They are:
1. We see the benefits now but the costs later.
2.The decision is made infrequently.
3. The feedback is not immediate.
4. The language is not clear.
Choosing a nice meal consists of clear language (“Our special tonight is deep-fried and smothered in cheese”), immediate feedback (“OMG! This is so good”), is made frequently (three times daily, more if you're like me), and has a mix of immediate and delayed costs (“That will be $27” or “I should have quit after three rolls”).
An investment decision on the other hand violates every single one of Mr. Thaler's conditions. It consists of intentionally confusing language (What does “market neutral” even mean?), has a massively delayed feedback loop (decades if you're smart), is made very infrequently (“Thanks for the inheritance, Aunt Mable”), and has benefits that are delayed to the point that we can scarcely conceive of them (36-year-old me finds it very hard to imagine the 80-year-old me that will spend this money). The crowd can provide us excellent advice on selecting a meal because it is a decision that is frequently made with results that are instantly known. Conversely, the wisdom or foolishness of a given investment decision may not be made manifest for years, meaning that the impatient crowd may have little wisdom to offer.
As we might expect from Mr. Thaler's research, the crowd gets it all wrong deciding when to enter and exit the stock market. They enter at the time of immediate pleasure and long-term pain (bull markets) and leave at the time of immediate pain and long-term pleasure (bear markets).
“Anyone taken as an individual is tolerably sensible and reasonable – as a member of a crowd, he at once becomes a blockhead.”— Friedrich Von Schiller
Jared Diamond's book “Collapse” [Penguin Books, 2011] recounts the story of a people who tried to do what so many investors attempt in WSBW: inflexibly impose their preferred way of life on an incompatible system. Mr. Diamond tells the story of the Norse, a once powerful group of people who left their homes in Norway and Iceland to settle in Greenland.
Those Vikings, who aren't exactly known for their humility, doggedly pushed forward — razing forests, plowing land and building homes — activities that robbed cattle of grazable farmland and depleted the few extant natural resources. Worse still, they ignored the wisdom of the indigenous Inuit people, scorning their ways as primitive compared to what they viewed as a more refined European approach to farming and construction. By ignoring the means by which the native people fed and clothed themselves, the Norse perished in a land of unrecognized plenty, victims of their own arrogance.
Like a Norseman in Greenland, you find yourself of necessity in a land with bizarre customs, some of which make little sense. This land is one in which less is more, the future is more predictable than the present and the wisdom of your peers must be roundly ignored. It is a lonely place that requires consistency, patience and self-denial — none of which comes easily to the human family.
But it is a land you must tame if you are to live comfortably and compound your efforts. The laws are few in number and easy enough to learn, but will initially feel uncomfortable in application. It won't be easy but it is surely worth it — and it is all within your power.