Five Questions: Behavior in Investing with Dr. Daniel Crosby

By Jack Forehand (@practicalquant) —  

There is probably nothing that hurts our investment returns more than our behavior.  We spend a lot of time debating things like whether we should invest in active or passive funds or whether value or momentum is a better investing factor, but in doing that we often lose sight of the thing that studies have shown detracts from our returns more than all of that.

The way we are wired as human beings has been very helpful for our survival as a species, but it is a significant hindrance for our investment portfolios.

For this week’s interview, we are going to take an in depth look at behavior in investing, how it hurts us, and what can potentially be done about it. My guest is psychologist Dr. Daniel Crosby. Daniel is the author of  three books on Behavioral Finance, including the recent best seller The Behavioral Investor.  He also recently became the Chief Behavior Officer at Brinker Capital.

Behavioral Finance can be a complex topic and many experts in the area tend to explain it with a level of complexity that is difficult for your average investor to comprehend, but Daniel is the opposite of that. He is able to take very difficult concepts and explain them in a way that not only is easy to understand, but also focuses on practical solutions rather than complicated theory.

Jack: Thank you for taking the time to talk to us and congratulations on the new position.

Everyone seems to agree that our behavior has a significant negative impact on our investment returns. As investors, we tend to buy high and sell low, which is the exact opposite of what we should be doing. The actual impact can be difficult to measure, though, and the research seems to vary with respect to how significant of an issue this is. I have seen studies that estimate that behavior impacts returns less than one percent per year and others with estimates of four or five percent. The methods that are used to calculate this impact have also been subject to significant debate. Common methods used to calculate the effect like asset weighted mutual fund returns have been subject to scrutiny since there are a myriad of reasons investors add money to or withdraw money from mutual funds other than bad behavior. What is the best research you have seen on the impact of behavior on investment returns and what are the best methods you have seen to calculate the effect?

Daniel: While there’s a fair bit of disagreement about how best to measure the behavior gap, there is very little doubt about whether or not it exists and what causes it. The most conservative estimates put the behavior gap at just over 1% and the most dramatic (and most widely cited) estimate has it at over 4%. But whether you think it’s 1% or 4% (and I tend to think it’s somewhere in the middle), we can all agree that fees, poor timing and improper product selection are at the heart of investor performance. The lessons of the behavior gap for me are watch your fees, do less than you think you should and diversify within and between asset classes. To the first point, Morningstar found that the best predictor of fund performance is fees, simply because paying too much directly erodes your performance and directly contributes to the behavior gap. It’s wholly possible for an uneducated investor to overpay by 1% or more for a product, which would get you all the way to the most conservative estimates of the gap. In terms of activity, Meir Statman and others have found that in each of the 19 countries they examined, that performance decreases with increased account activity. Bearing this in mind, a big part of managing the behavior gap becomes getting investors to do as little as possible. Finally, there’s diversification which makes the ride more palatable for the average investor and is low ego made flesh. A diversified portfolio that owns the world is a concrete way of saying, “I have no idea what’s going to happen and I’m cool with that.”

Here is an excellent chart from Betterment with estimates of the behavior gap:


Jack: Despite the fact that we continue to learn more about the effect of behavior in investing, the problem continues to persist. Given the way human beings are wired, that may be inevitable, but there is the potential that continued research in this area combined with technological innovations could improve things over time, and may have done so already. Do you think the problem is getting better or do you think that our nature as human beings will always limit our ability to solve this?

Daniel: Advances in behavioral finance can improve significantly, but will never fully eradicate, the tendency of investors to make poor decisions. The reason this is so is that there’s a profound “knowing-doing gap” that owes to the difficulty of implementing things that are psychologically tough, even if we know them to be true. Smoking is a great example. For a long time, the dangers of smoking were not fully understood and so in the 1960s, 42% of adults in the US smoked. As time went on, science began to tell us in great detail about the dangers of smoking, and while that has improved the ability of the public to make better decisions about their health, millions of people still smoke. Currently, 14% of Americans smoke and I’d wager that not a single one of those 16 million people believes that it’s a good idea. Likewise, as investors get more and more information about the impact of their behavior, many will make better decisions, but there will always be a significant minority of the population that makes ill-advised decisions about their wealth, simply because it’s emotionally expedient.

Jack: Investment advisors commonly struggle with this issue because it can be very difficult to identify an investors ability to stick with an investment approach up front, and you often only find out about a client’s ability to stay the course in tough times during the stress of a bear market or an underperforming period, which is less than ideal. Many advisors use things like up front client questionnaires to try to gauge a client’s willingness to accept risk, but that type of approach has been largely unsuccessful. Over the years, I have seen advisors have more success with things like focusing heavily on the worst-case scenarios in the sales process, using base rates to show the likelihood of specific outcomes, and trying to look at risk in dollar terms instead of percentages, but it seems like nothing is all that successful. What are the best methods you have seen for assessing someone’s ability to tolerate difficult periods before those difficult periods actually come?

Daniel: For advisors looking to help clients make the best decisions, I think that three things are paramount: managed expectations, a deep understanding of financial history and just-in-time support. One of our tendencies as a human species is to project the circumstances of the recent past into the future indefinitely. Incidentally, this is just about the opposite of how capital markets work, with elevated past returns tending to be a harbinger of lean times ahead and vice versa. So, a client who has recently lived through five years of 15% annualized returns is likely to expect that going forward, when the reality is likely far less appealing than that. It is job one of an advisor to give her clients the unvarnished truth about future return expectations, even when it’s not great news. Second, they need an understanding of financial history that transcends simple intellectual knowing. For instance, you know, intellectually, that you’re going to die one day, but it’s likely nothing you really think about until you have a near miss or get a scary diagnosis. Someone who has just been in a car accident knows that they are going to die in a more meaningful way than someone who has not and is likely to make better choices as a result (e.g., spending time with loved ones). Advisors need to work with their clients to give them as visceral an understanding as possible of just how much bear markets can hurt. This can include everything from role playing to using actual dollars when discussing scenario planning to reviewing their reactions to past markets. It’s not enough for a client to know that markets are volatile, they have to feel it as well. Finally, despite every effort at inoculating clients against bad behavior, it’s inevitable that some folks are going to panic in volatile markets which is where just-in-time reassurance, support and advice come in. I know that donuts aren’t good for me but I choose to eat them anyway from time to time, because I don’t have a personal trainer to slap the donut from my hand at the cash register. Financial advisors can intervene at the point of maximum fear or greed to effectively swat down a bad decision as it’s occurring. Education remains a weak predictor of good behavior and sometimes the only thing that will work is someone to reassure you that you’re making the right choice in a moment of intense emotion.

Jack: The potential impact of robo advisors on investor behavior is a very interesting topic. On one hand, robo advisors have the ability to use technology to test and implement approaches that could be very helpful in this area. For example, when Betterment started providing clients with the tax implications of their decision to sell on the confirmation screen, it helped to limit selling during down periods. But on the other hand, it will be tough for technology to ever replace the support that a person can provide during difficult times. What are your thoughts on how Robo Advisors will impact investor behavior going forward?

Daniel: Throughout this interview, I’ve spoken to a handful of things that I think help manage investor behavior, some of which I think robo-advisors do extremely well and others that I think are a less natural fit. In terms of managing fees, providing adequate diversification, and even managing expectations, I think that robos are extremely well equipped to do what they do. My primary concern, that I’ll admit remains an open question, is whether or not robos can provide the sort of just-in-time support that I spoke about above. I think that robo-advisors are wholly capable of figuring out who needs help and even providing them with research, nudges and advice around how best to proceed. What remains to be seen, since no robo has lived through a true bear market, is whether or not these nudges are as powerful as the personal admonition to stay the course from a trusted advisor. Some of the robo-advisors are enormously thoughtful about client behavior and I know that they will be making every effort to provide this sort of advice and I’m excited to see what the outcome is.

Jack: The topic of loss aversion has been a hot one lately. It has been widely accepted that people feel more pain as the result of a loss than they do pleasure from an equivalent gain. And that leads us to sometimes make poor decisions. That fact has been part of the foundation of behavioral economics. But a recent article by David Gal in Scientific American has called the whole thing into question.

In the article he wrote the following: Contrary to claims based on loss aversion, price increases (ie, losses for consumers) do not impact consumer behavior more than price decreases (ie, gains for consumers). Messages that frame an appeal in terms of a loss (eg, “you will lose out by not buying our product”) are no more persuasive than messages that frame an appeal in terms of a gain (eg, “you will gain by buying our product”).

In a separate interview I saw recently, Nassim Taleb didn’t call the concept of loss aversion into question like Gal did, but instead challenged the belief that it is irrational. His argument was that since you cannot recover from losing all your money, it is perfectly rational to fear losses more than you enjoy gains.

So the traditional theory that loss aversions exists, and that it is irrational, have both been challenged. Are you still a believer in loss aversion and what are your thoughts on these arguments?

Daniel: I thought that Barry Ritholtz did an excellent job of laying out the arguments *for* loss aversion in light of these recent challenges in his piece, “Is Loss Aversion a Fallacy?” To summarize his thinking, extraordinary claims require extraordinary proof and Barry and I agree that the challenges to loss aversion have not yet met that high standard. If you want to attack an idea that has considerable intuitive and empirical support, I’m going to need more than the few studies named in the Scientific American article. Taleb’s argument that loss aversion isn’t irrational is a more interesting one, in my opinion. I wrote in my most recent book, The Behavioral Investor, that one of the reasons that Homo Sapiens has flourished is that we were more loss averse than some of the other hominid species that used to dot the globe. We were more scared of losing, and thus, quicker to pack and leave when things got dicey and more apt to prepare. But the rationality of a behavior can’t be divorced from its larger context and this is especially true of loss aversion and money. If your tendency to be risk and/or loss averse leads you to create a six month emergency fund to prepare for a rainy day, that’s a wonderfully rational behavior. But if you’re loss aversion leads to eschew equity investing in favor of more “safe” alternatives, you may fail to even keep up with inflation and be unable to retire in the manner you most desire. That, I would say, is irrational behavior. The trick thing about loss aversion is that our worst fears can materialize as a direct consequence of trying not to lose. Someone who is scared of getting a divorce and never makes himself vulnerable to other people is exhibiting irrational loss aversion and has brought about the certainty of loneliness in his efforts at trying to escape the possibility of loneliness.

Jack: Thank you for taking the time to talk to us today. If investors want to find out more about you, where are the best places to go?

Daniel: The best to places to reach me are via Twitter or LinkedIn. You can find out more about my podcast Standard Deviations here and my book The Behavioral Investor here.