CPA Conversations hosts Jim DeLuccia and Bill Hayes step aside for this special episode where I interview Dr. Daniel Crosby on his latest book, The Laws of Wealth: Psychology and the Secret to Investing Success. We explore the behavioral factors that determine the success or failure of investors, the value of robo-investing platforms, and why “diversification means always having to say you’re sorry.”
By: Mike Briglia, CPA, CFP, Financial Consultant, Pillar Wealth Advisors, LLC
I'm Mike Briglia, CPA, CFP, and PICPA member, and pleased to be a special guest host of this episode of CPA Conversations. If you're a first-time listener, CPA Conversations is the PICPA's podcast series where CPAs and other professionals discuss pressing matters affecting the accounting industry. I've also been a member of the PICPA's personal financial planning committee for several years and I'm pleased to be joined by Dr. Daniel Crosby, author of The Laws of Wealth: Psychology and the Secret to Investing Success.
I recently read his book which was published back in 2016, and I'm excited to explore some of its principles a bit more in depth. Dr. Crosby is a psychologist, behavioral finance expert, and asset manager and I might also add he's a bit of a historian and comedian as well in terms of his writing style. Dr. Crosby, thank you for joining me on the program today.
[Dr. Crosby] My pleasure. It's great to be here.
You've written a couple of books now, including a New York Times Best Seller. Would you mind just sharing with us briefly your inspiration for writing The Laws of Wealth, and really how it builds on your prior work.
[Dr. Crosby] My inspiration for writing The Laws of Wealth was candidly just taking all of the great bits and pieces of other research and other works that I was familiar with and trying to make it as accessible for the investor as possible. Behavioral finance is a discipline that does powerful work that has the potential to really benefit the lives of the clients that we serve, but unfortunately, the findings of the behavioral finance don't always trickle down to Joe and Jane Q investor because it's sort of ivory tower. These are complicated studies, they tend to stay in the realm of academia. I'm a humble young man from Alabama and I use that background to try and make these things fun and approachable and applicable.
Yes, behavioral finance certainly is at least, relatively anyway, a new and emerging area in the financial world. In part one of the book, you highlight what you call the 10 essential laws or perhaps the behavioral factors which tend to determine our success or failure as investors. You point out quite well that we ourselves can be our own worst enemies when it comes to managing our investments and finances. Why is that, in your experience and in your research?
[Dr. Crosby] One of the reasons is that the things that have made us successful as a species, the things that have made us the top of the food chain over the last millions of years actually don't make us great investors; they actually make us very bad investors. For instance, one of the reasons why homo sapiens outlasted other humanoid species is that we were scared. And when other people were taking dumb risks we were moving on and managing our risks and making sure that our bases were covered. The fact that we're risk averse and loss averse from an evolutionary perspective, from a psychological perspective has done the human race a great deal of good and has kept us around, but if you apply that same risk aversion and loss aversion to financial markets at a time when we're living longer and longer, and inflation is what it is, we're not able to compound our wealth at a sufficient enough clip to have the kind of retirement that we've dreamed of.
It's a tricky thing and I talk in the book about what I call Wall Street “bizarro world,” which is where the rules of finance are really topsy turvy from the rules of every day. Lessons that have worked well for you elsewhere in life actually tend to serve you quite poorly in financial markets and that's a hard switch to make on the dime.
Fascinating perspective. If you had to rank them, which are the behavioral factors or tendencies that you list in the book that create the most problems for investors?
[Dr. Crosby] This is of course like asking me to choose my favorite child, but I'm going to go ahead and give it a shot anyway. I don't remember which chapter it is. I think it's toward the end of the 10, but there's one called “you are not special,” which is a hard one to read perhaps, but basically, it's speaking to our tendency as a human race to be overconfident. I think this drive towards egotism and overconfidence is sort of the bias that emboldens and enables all other biases.
One of the things that I stressed in The Laws of Wealth and in my newest book Behavioral Investor is that you have to be a good investor, you have to strip yourself of the idea that you are lucky, that you're smart, that you are different, that you are better and as I show in those books, that's something that is very, very endemic to human kind because it's an attitude that helps us get out of bed in the morning and it gets us moving and it leads us to do pro social positive things like start a restaurant or start a small business because if we looked at the odds, I mean, starting a restaurant is a terrible idea probabilistically yet you and I are glad that people start restaurants. The rules again of how you want to dream and live your life are one thing and the rules of how you want to play your investments are very different thing. We, especially men, tend to be overconfident and until that's in check everything is going to be in shambles.
Yes, I thought that was very interesting what you pointed out in the book about the research between the differences between men and women in this particular area. I think just trying to summarize what you're saying, it's a little bit of disavowing yourself that you can outsmart the wisdom of the crowd. Is that another way to look at it?
[Dr. Crosby] Yes, it is and there's a couple of particular types of overconfidence. One is we feel like we're lucky. People think, if you ask people, are you likely to get divorced? Most people will say no, even though there's, statistically speaking, about a 50 percent chance that you'll get divorced. If you ask people, what's your likelihood of winning the lottery, they'll wildly overstate their likelihood of winning the lottery while they understate the likelihood of getting cancer, or getting divorced, or something like that. Yes, people mis-weigh these probabilities. We think we're smarter than the next person.
Again, men in particular. I cite a study in The Laws of Wealth where it showed that of 700 men surveyed, 100 percent thought that they were friendlier than average, 95 percent thought that they were funnier than average, and 94 percent thought that they were better looking than average. It's just not how averages work as it turns out though.
Although it's true for present company, right?
[Dr. Crosby] Well, yes. You and I, for sure.
One of the laws I find particularly important and very hard in my experience for the average investor to grasp is that diversification means always having to say you're sorry. Can you please say a little bit more about what you mean here?
[Dr. Crosby] I mean I messed the numbers up, but I looked at some charts yesterday that showed the performance by country of different ETFs, different investments over the last 11 years, and the U.S. was up something like 150 percent. During that time Japan was up 10 percent or 12 percent, and then most of the rest of the world was down or flat. When you look at that, people get upset. They go, "Well, why didn't I just have all my money in the S&P 500? If it's been written for 10 years, why have I not had all my money there?"
I've heard it likened, I forget who said this, but I've heard it likened to having a large family. If you have 10 children, there's a really high likelihood that one or two of them will be misbehaving at any given time.
The same is true of asset classes. You can and should ought to own two handfuls of different asset classes, and if that's the case, and it should be the case, if they're all going up at the same time or all going down at the same time, something's wrong. Like, you should own real estate, real assets, equities, international equities, emerging markets, you should own all of these things and one of them's always going to be giving you heartburn. That's just sort of a fact of life, but you have to program yourself to have a little schadenfreude say, "Look, the fact that some of my holdings have not been doing as well as the S&P over the last 10 years, that when the S&P revert to the mean, I'm probably going to be all right." It's just, you're always having to say you're sorry for one or the other holding of yours or your clients.
Very interesting. There's also a little bit of a tie back there to the point about overconfidence in terms of maybe thinking that you can predict with certainty which asset class or geography is going to help perform over the next 12 months, which the stats on that is very, very poor, I'm sure.
[Dr. Crosby] Diversification within and among asset classes is basically humility made flesh. This is sort of the personification of saying, I don't know what the future holds, so, I'm going to be humbled and hold it all.
Another law, I think, that's critical to explain is the notion that risk is not a squiggly line, which is an interesting caption. With the memories of 2008 and 2009 still fresh and in the minds of many investors, can you describe your view of risk and what the investment community tends to get wrong about it.
[Dr. Crosby] We talk as an investment industry, we talk about systematic risk, we talk about unsystematic risk, idiosyncratic risk and market risk, but I think we tend to ignore a third and most important type of risk which is behavioral risk because if you look at the Dalbar study and there's a handful of others that corroborate directionally what Dalbar has found, over the last 30 years, the market's gotten eight and a quarter percent, and the average investor has realized less than half of that gain, so the average investor's gotten 4 percent and inflation has been 3 percent. The biggest danger to most people is that they're going to get in and out at the wrong times that they're going to try and game it but they're going to have overly-concentrated stock positions. It's all this behavioral mismanagement is really the biggest danger because something that erodes your performance at a level of 50 percent over long periods of time is quite, quite risky.
We spend a ton of time wringing our hands about preparing for the next recession, the next depression or the next downturn. I talk in my book about over the last 113 years there have been 123 corrections. They're as regular as your birthday. You see it here, the markets dipped about 10 percent from its high this year, give or take and people again are acting like it's the end of the world. If you look at the last 35 years, the market has dropped an average of 14 percent a year at some point during the year and has ended the year positive 27 of those 35 times. It's kind of comical and mystifying to me how every time there's any volatility we act like we've never seen it before when we see it with such great regularity.
But yes, that's the case. The ups and downs of the market are nothing compared to your own irrationality and your own poor decision making when it comes to your ability to compound wealth.
Part two of your book gets into a bit more of the practical advice for overcoming some of these behavioral tendencies that we tend to have as investors. Can you say a little bit more about what you describe as rules-based investing or, borrowing the acronym from baseball here, RBI, and how RBI can help the average investor?
[Dr. Crosby] Part two is admittedly a little lengthier than part one, and I love it. It's my favorite part to talk about. I make a case in part two of the laws of wealth for something called rules based behavioral investing or RBI because I'm a big baseball fan, Go Cardinals. What I do there is I try and take some steam out of the active versus passive conversation because I feel like active, nominally active and nominally passive approaches and there's, by the way, very little agreement on what even counts as one or the other, but I think that's sort of a red herring. I think that's the wrong conversation to be having. I make the case in part two of The Laws of Wealth that whether or not your strategy is nominally active or passive is less important, than whether or not it adheres to a couple of basic principles. I call them my four C's.
The first of those is consistency. I cite research in the book, it's a meta-analysis, which is effectively a study of all the studies. It's a meta-analysis of over 200 different studies that looked at discretionary human decision making versus following simple rules and found that well over 90 percent of the time, the simple rules beat the human discretion and they do so a lot more cheaply in the world of asset management because it's cheaper to pay an algorithm than it is a bunch of CFA's and PhDs. I believe that the best investment processes are automated, are rules based or consistent. That's my first C.
The second one is clarity. People tend to have what my friend Dr. Brian Portnoy calls a fetish for complexity in the world of financial services, and we feel that something, a complex dynamic system like the stock market has to be solved with equally complex and dynamic solutions. But as Einstein said, you can't solve a problem at the level of thinking that created it. The great irony of good investment management is that it's quite simple. You don't need convoluted expensive complex products, I think, to do well in the market. You need clarity, you need simplicity that's based on a couple of those rules we saw on the first C.
The third C is for courageousness, which is all about automating the process of doing the right thing; effectively buying low and selling high. I talk in the book about how that's the easiest thing in the world to say and the hardest thing in the world to do. I actually sat by a woman on a plane recently who asked me what I did, and when I told her, she said, "You went to eight years of college to tell people to buy low and sell high?" I thought that was pretty great. I think my parents speak the same thing sometimes. But courageousness is all about locking in this process. Whether it's a system of going sort of counter trend or whether it's a value investing system that kind of locks you into the process of buying unloved, undervalued stocks, I think courageousness is paramount.
Then the fourth one is conviction, and I'll offer that one with a bit of a caveat. What I say there is effectively, if you're going to actively manage money, have conviction or don't bother, because we live in a world today where investors can get index funds, Large Cap U.S. Index Funds for free in some cases, certainly as low as three basis points, three 100th of a percent. I mean, you can get really good, low conviction product for next to nothing.
So, my thought here is, be in one camp or the other. Either have an opinion and have conviction or index and pay like you're indexing. Keep your fees very, very low. I think the dirty little secret of our industry is that many, many actively managed funds are low conviction in terms of their positions. They differ hardly at all from a free or nearly free benchmark, and they're charging active fees. That fourth one is where I sort of make the case that look, get in or get out and if you're going to get in get all the way in and try and find a position that is both diversified but does so in a way that looks different for the benchmark that you could have for free.
Yes, you point out in the book about the active share measurements that have become very popular as pointing out that point relating to just how much conviction an investment manager might be using or not using. Your comments though in the four C's, just given in today's world of automation and AI: do you think in your opinion that robo investing platforms are helpful in ridding ourselves of these behavioral tendencies that get us in trouble given their algorithmic approach to investing?
[Dr. Crosby] Robo investors do one thing very well and it's not the most important thing though. What robo investors do very well is that they allocate your money very efficiently. These folks have done the math, they've done the research, they've looked at the science to give you a low fee, nicely allocated portfolio. They can do that all day long. But as we've discussed throughout today, I don't think that's the greatest value added by working with a financial professional. I don't think there's a single robo advisor that has seen a bear market. I think the true test of robo advice will be whether or not robo advice keeps people in their seats the next time we have a 35, 40 percent drawdown because we're candidly kind of due.
The next time the market drops by a third, if robo platform through electronic nudges and other gate keeping systems can keep people invested and help them right out of that storm, then I think they'll have something to shout about, but if people are just using it as sort of a glorified E-trade and it doesn't help people make good decisions then I think that they won't have lived up to the fullest measure of their creation. So, they do one thing extremely well, but the most important thing I think is an open question.
There’re benefits then to the dual approach of maybe marrying the robo investing platforms with professional management to help with behavioral aspects and linking your investment strategy into a broader comprehensive financial plan?
[Dr. Crosby] It's interesting because you even see this in the evolution of the way that robo is marketed themselves. They came out of the gates effectively saying, "Ha, ha, financial advisers your time is up. We're going to replace you," and then quickly, I think, pivoted for practical and behavioral reasons to saying, "No, we can work together. We can help you streamline the allocation process, you can do the hand holding and behavioral coaching and there's value added by both things," which is I think is a more sensible middle path.
Part two of the book struck me a little bit as a value based or a fundamental stock pickers manifesto, if you will. For example, many references that you use to Warren Buffett and Benjamin Graham and other great value investors. Given maybe the long-term stats and goodness associated with using value-based principles, how do you blend in or should you blend in the growth and momentum style of investing into a comprehensive rules-based investing strategy and program?
[Dr. Crosby] Yes, it's a great question. As you know, value investing is something that is embraced by people like me with nearly religious zeal. I've heard Warren Buffett and others say, "Look, when you learn about value investing, you either get it or you don't. You like it or you don't." The same could probably be said of technical analysis in different ways of looking at equity markets, and I immediately fell in love with value investing. I immediately got it and thought of momentum and technical indicators are sort of voodoo early on, but I have to say that I have come around and as you'll see in the book, I really advocate for what would most easily be called sort of a value quality momentum combination strategy. The reason for that being, I think they all share something fundamental.
As I've broadened my thinking and become less close minded about what works and what doesn’t, and I've just looked at the research, I think that the best strategies share a couple of common traits. The first of them is that they have a basis in theory. There needs to be philosophically a reason why this works because if they're not, it could just be correlation effects. We see all kinds of things like the Super Bowl indicator, of I forget if it's the NFC or the AFC, but the Super Bowl indicator about whoever wins the Super Bowl is a good predictor of what happens in the market and historically that's been the case. There's data there but there's no theory behind it. It's on its face stupid.
There needs to be good theory behind it. There needs to be good data behind it, which is the second qualification, and the third thing is that it needs to have a behavioral element because the behavioral piece is what keeps it around, is what leads it from being arbitraged away because if you look at things like calendar effects and other market anomalies that have been discovered, when there's no paying premium, when there's no discomfort associated with it, it quickly gets arbitraged away. But I think things like value and momentum tick all three boxes. There's data there to support it, 200 years’ worth in the case of momentum. There's data there, there's a reason why it works theoretically and there's also behaviorally a reason why it's difficult to implement.
I think you're also saying that you need to have conviction for the right things, things that are grounded in facts and data and supporting your longer-term investment strategy and the ability to just really stick with it as well.
[Dr. Crosby] Yes, it's interesting. Dan Egan who's the head of behavioral finance at Betterment, a robo adviser, wrote an interesting article recently that said something to the effect of, all good investors need religion and he's not talking about regular religion. He's saying, all good investors need a belief in their system, whether it's value or momentum or indexing because your belief in that system, your conviction to use your word is what keeps you in there through thick and thin. I think that's an important concept.
For the investment management practitioner who may be listening, what would RBI look like from a portfolio construct perspective? Meaning, can you use ETFs, can you use mutual funds, or is it more individual stock and bond picking?
[Dr. Crosby] You could definitely use ETFs. I think it looks different ways as long as it checks these boxes. As long as it's rules-based rooted in simplicity and automates the process of doing the right thing at the hard time, I think it can look like anything. You could make a case for a DSA type multifactor approach. You could make a case for mutual funds or ETFs, you could make a case for an AQR-managed futures fund in an RBI portfolio because again, it's more about the systematic nature of it in avoiding bias than it is any specific way of going to market.
It's vehicle agnostic, if you will, so long as it just kind of ties back to the four C's there as you described to us earlier.
[Dr. Crosby] That’s right.