Speaker 1: How do we fool ourselves in the stock market? And
Speaker 1: what does neuroscience have to do with investment? And what
Speaker 1: does any of this have to do with Isaac Newton
Speaker 1: or the Dutch East India Company which ran for two
Speaker 1: hundred years, or Kodak or the way that zebras like
Speaker 1: to herd or instincts or emotions and almost two hundred
Speaker 1: different cognitive biases. Welcome to Innercosmos with me David Eagleman.
Speaker 1: I'm a neuroscientist and an author at Stanford and in
Speaker 1: these episodes we dive deeply into our three pound universe
Speaker 1: to uncover some of the most surprising aspects of our lives.
Speaker 1: Today's episode asks what do brains have to do with
Speaker 1: the stock market? So there's this old joke about a
Speaker 1: man who's looking for enlightenment, and he goes on a
Speaker 1: journey to find the wise man, and he hipes snowy
Speaker 1: mountains and fords rivers, and after many months of toil,
Speaker 1: he summits a peak and he finds the wise man
Speaker 1: sitting there cross legged at the top. And the man
Speaker 1: drops to his knees and he says, Oh, wise one,
Speaker 1: what profound words of wisdom can you share? With me,
Speaker 1: and the wise man looks at him and says, by
Speaker 1: low sell Hi. Now, whether you think that that's the
Speaker 1: world's funniest joke, it doesn't matter, because the fascinating part
Speaker 1: is that the joke is stuck around for generations.
Speaker 2: And this is because the.
Speaker 1: Advice is so simple, and yet most people in the
Speaker 1: stock market find it incredibly difficult for their brains to
Speaker 1: stay on track to follow that advice. Instead, they buy
Speaker 1: a stock once it's shot way up and everyone's talking
Speaker 1: about it, and when the stock starts crashing they do
Speaker 1: a panic cell. But of course that kind of bad
Speaker 1: decision making is just the very start of it. We
Speaker 1: humans do all kinds of bad decision making in the
Speaker 1: stock market, or more generally, when we're thinking about how
Speaker 1: to invest our savings. Why, well, it's because we're not
Speaker 1: like mister Spock and star Trek, who knows how to
Speaker 1: make optimal logical decisions. Instead, we are yoked with psychologies
Speaker 1: that have long evolutionary histories, and as a result, they
Speaker 1: have all sorts of flaws in their reasoning, which we
Speaker 1: generally summarize as cognitive biases, which are these patterns that
Speaker 1: you see where we deviate from rationality in our decision making,
Speaker 1: we do things that are often irrational.
Speaker 2: Why do we do this?
Speaker 1: Well, the world is extremely complicated, but your brain is
Speaker 1: always trying to get a grasp on it and have
Speaker 1: some control over what you can do. And so with time,
Speaker 1: like millions of years or sometimes tens of millions of years,
Speaker 1: you develop these mental shortcuts that work much of the time,
Speaker 1: but they're not actually strictly logical. Now, in my book Incognito,
Speaker 1: I wrote about how much of your brain's activity is
Speaker 1: running under the hood, and my analogy was that the
Speaker 1: conscious mind, which is the part of you that flickers
Speaker 1: to life when you wake up in the morning, that's
Speaker 1: like a broom closet in the mansion of the brain.
Speaker 1: Most of what you think and do and act and
Speaker 1: believe you have no access to. As a result, even
Speaker 1: though we typically feel like we are excellent stewards of
Speaker 1: our decision making, there are all kinds of irrationalities that
Speaker 1: humans display. Now. Not being like mister Spock is typically
Speaker 1: not the end of the world, and obviously for our species,
Speaker 1: for all its flaws, we continue to get by. But
Speaker 1: these cognitive biases do show up in a much bigger
Speaker 1: way when we look at how people deal with economics.
Speaker 2: Now.
Speaker 1: Traditionally, economics has been studied in the context of an
Speaker 1: ideal decision maker, often called homoeconomicus and homoeconomicists is perfectly
Speaker 1: rational and not influenced by shiny objects or by what
Speaker 1: his friends are doing. But a new field began to
Speaker 1: blossom a few decades ago, and we now call that
Speaker 1: behavioral economics or neuroeconomics, and the idea is to understand
Speaker 1: how people actually make decisions and what sorts of mistakes
Speaker 1: they actually make. And I spoke about this in episode eight,
Speaker 1: which was about how your brain decides what it's actually
Speaker 1: going to buy, like which car and which restaurant you're
Speaker 1: going to go to, and which ice cream flavor you're
Speaker 1: going to choose. But today I want to hit a
Speaker 1: different facet of this top which is you come home
Speaker 1: from work with your paycheck and you decide I'm going
Speaker 1: to do the smart thing and invest this money, which
Speaker 1: is an important idea, but people often lose tons of
Speaker 1: money in the stock market. I've seen this happen with
Speaker 1: friends of mine, and there's been a proliferation of phone
Speaker 1: apps that let you do trading in a way that's
Speaker 1: like an addictive online gambling game and they lose tons
Speaker 1: of money. But not everyone loses money in the stock market.
Speaker 1: In fact, academics study this and generate whole fields that
Speaker 1: wind Nobel prizes about how to allocate assets. So where's
Speaker 1: the disconnect. Well, it has to do with the brain
Speaker 1: and our psychology and with these cognitive biases. So I
Speaker 1: called up my friend Mark Mattson. Mark is an entrepreneur
Speaker 1: and deeply studies the science of investing. He's been in
Speaker 1: the financial industry his whole life, and more than anyone
Speaker 1: I know, he's seen exactly the way that humans be
Speaker 1: behave and the difference in the way they would behave
Speaker 1: if they were.
Speaker 2: Doing so optimally.
Speaker 1: And he's just written a new book called The American Dream.
Speaker 1: And the part I want to zoom in on today
Speaker 1: is the part about how we make decisions in the
Speaker 1: stock market. So here's my conversation with Mark Mattson. Okay,
Speaker 1: So Mark, one thing I talk about a lot on
Speaker 1: this podcast is this idea of the internal model, which
Speaker 1: has been building up since the.
Speaker 2: Day you were born.
Speaker 1: Your brain is locked in silence and darkness and trying
Speaker 1: to model the world and understand what's out there. Now
Speaker 1: you use a term that I believe was introduced by
Speaker 1: the scholar Kenneth Burke originally that I love, which is
Speaker 1: this idea of a screen or many screens tell us
Speaker 1: about that.
Speaker 3: Yeah, so most people think that they have an objective
Speaker 3: view of the world, and their view is the quote
Speaker 3: unquote right view. What he was talking about was you
Speaker 3: don't really see the world. What you actually see is
Speaker 3: what the screens that you have allow you to see.
Speaker 3: And the screens are created linguistically from out of language.
Speaker 3: So some of these screens are created on purpose. So
Speaker 3: if you're a doctor, you spend many, many years creating
Speaker 3: all the linguistic screens around, you know, being a doctor.
Speaker 3: But we have those screens developing all the time, and
Speaker 3: most of them aren't on purpose.
Speaker 2: They're kind of on accident.
Speaker 3: The experiences we had in life, teachers, we had in life,
Speaker 3: and we are unaware that we actually have a screen,
Speaker 3: which then limits us. A lot of people talk about mindsets,
Speaker 3: but I think mindset seems like something that you can
Speaker 3: easily change. Well, I'll just change my mindset. The screen
Speaker 3: doesn't seem like a screen that you can change. It
Speaker 3: actually seems like the truth, and that locks us into
Speaker 3: the same behaviors.
Speaker 2: Over and over and over again.
Speaker 1: You mean, because we believe whatever our screens are telling us.
Speaker 3: We think that is the world out there. I know
Speaker 3: that to be true. Yeah, well, something will happen. We'll
Speaker 3: make up a story about it, a screen about it.
Speaker 3: In the book, I talk about money demons or negative
Speaker 3: beliefs around money and our relationship to money, and once
Speaker 3: they're formed, they take control. It's kind of like the
Speaker 3: movie Aliens where the alien slams onto somebody's face and
Speaker 3: that's all they can really deal with is the alien.
Speaker 3: It takes over, It has complete control, and we don't
Speaker 3: even realize it's happening.
Speaker 1: So give us some examples these money demons.
Speaker 3: So one money demon kind of like the underlying demon
Speaker 3: of all is I don't have enough. I don't have
Speaker 3: enough to have a successful life. I don't have enough
Speaker 3: to create my business the way I want to. I
Speaker 3: don't have enough to live powerfully. I don't have enough
Speaker 3: to feel fulfilled. So this this kind of a scarcity
Speaker 3: beliefs system them a scarcity screen that money, and it's
Speaker 3: just a screen. Money is hard to make, hard to invest,
Speaker 3: and hard to keep, so it's a screen of suffering
Speaker 3: and struggling. Another's related screen would be a victimhood screen,
Speaker 3: in that I'm a victim and I can't really create
Speaker 3: what I really want to create with my life because
Speaker 3: I'm locked in from some kind of victim mentality, as
Speaker 3: opposed to an American dream screen, which would be through
Speaker 3: hard work, individualism, creativity, focusing on creating value for others.
Speaker 3: And I first became aware of this, you know, with
Speaker 3: a story with my grandfather and my father, and they
Speaker 3: had two In fact, the screens that they had were
Speaker 3: so extreme it was like they weren't even living the
Speaker 3: same world, like it was two different dimensions, and it
Speaker 3: made it very hard for them to communicate and have
Speaker 3: a relationship throughout life.
Speaker 1: Let's double click on that. What were those screens for
Speaker 1: your grandfather and your father?
Speaker 3: Well, so, my grandfather grew up in the coal mines
Speaker 3: and the chemical factories in West Virginia, and he had
Speaker 3: a screen that actually that money was evil and anybody
Speaker 3: that had money actually stole it and took advantage of
Speaker 3: other people, so much so that when he was actually
Speaker 3: offered a raise and to be a foreman at Union Carbide,
Speaker 3: where he worked, he refused to take it because he said,
Speaker 3: I don't want to be the man, and I don't
Speaker 3: want to take advantage of other people. He didn't see
Speaker 3: an opportunity to create wealth for his family, to be
Speaker 3: a foreman and actually create value for the people under him.
Speaker 3: And my dad on the other hand, and he was
Speaker 3: driven by a question that was why am I doomed
Speaker 3: to live in West Virginia and why am I doomed
Speaker 3: to suffer here? And my dad had a different question
Speaker 3: which created a different screen. His question was how can
Speaker 3: I escape this abject poverty and create wealth and prosperity
Speaker 3: for myself and other people? And he saw money as
Speaker 3: a way of creating values for others, and hate believed
Speaker 3: in capitalism, and my grandfather didn't. And those who my
Speaker 3: grandfather died alone of inmphysema from the chemical factory that
Speaker 3: he worked in. People will actually die to keep their screens.
Speaker 1: Now you believe that the investing industry is broken, tell
Speaker 1: us about that.
Speaker 3: Well, the investing industry is seriously broken because it's based
Speaker 3: on a very destructive screen. And that screen is something
Speaker 3: we call investor prediction syndrome. People believe and have been
Speaker 3: fed the idea that you need a forecast, either an
Speaker 3: economic forecast or a political forecast, and then based on
Speaker 3: that forecast, you can foresee the future and then pick
Speaker 3: all the best stocks and get in and out of
Speaker 3: the market at the right time, and or pick the
Speaker 3: best managers. But all the academic research is conclusive that
Speaker 3: all the noble and predictable information about the future is
Speaker 3: already in the price. Therefore, only unknowable, unpredictable events will
Speaker 3: change prices going forward. And so people are gambling and
Speaker 3: speculating with their money and they don't even realize that
Speaker 3: they're doing it. And that screen is so embedded in
Speaker 3: the financial industry that it goes unacknowledged. You turn on
Speaker 3: the TV and they're asking, well, what's going to happen
Speaker 3: with the election, and what's going to happen with inflation?
Speaker 3: And what should I invest in based on this forecast?
Speaker 3: And it doesn't it begs even common sense. I mean,
Speaker 3: obviously no one can predict the future, and if they did,
Speaker 3: they wouldn't tell you on TV.
Speaker 2: So it's crazy, right.
Speaker 1: And one of the things that really struck me in
Speaker 1: your book was you looked at a number of these
Speaker 1: predictions where people said in magazines or on blogs or
Speaker 1: articles or whatever about you know, hey, these are the
Speaker 1: stocks to pick for this year, these are the killer stocks.
Speaker 1: They're going to make you a bunch of money. And
Speaker 1: you went through you analyze what actually became of those
Speaker 1: as compared to let's say the S and P five hundred,
Speaker 1: and what did you find there?
Speaker 3: Well, it's the average investor historically averages trying to do
Speaker 3: asset allocation investor money it earns about two and a
Speaker 3: half three percent and the SMP, for example of clocks
Speaker 3: in around ten percent. So on average, people are throwing
Speaker 3: away three to six percent of their return trying to
Speaker 3: pick the best stocks and trying to get in and
Speaker 3: out of the market. And if you find someone that
Speaker 3: got lucky enough to beat the market, statistics show that
Speaker 3: that was just luck and not skill. So it's it's
Speaker 3: extremely destructive for people that are trying to plan for
Speaker 3: their future and their have their American dream. And it's
Speaker 3: and it's driven by all kinds of biases, mistakes and
Speaker 3: thinking and logic. And for example, one of one of
Speaker 3: the biases that people have is hindsight bias. And they
Speaker 3: maybe they picked twenty or thirty stocks and two or
Speaker 3: three of them do really well, in hindsight, they'll remember
Speaker 3: only the ones that did really well, and they'll forget
Speaker 3: about the ten or twenty that they picked that didn't.
Speaker 1: Do well, and they'll think, I'm pretty good at this,
Speaker 1: and they'll.
Speaker 2: Go, wow, I'm great at picking stocks.
Speaker 3: But they never really calculated their total return and it
Speaker 3: gives them which leads into another bias, which is over
Speaker 3: confidence bias.
Speaker 2: They feel way.
Speaker 3: More confident in their abilities than they actually are. And
Speaker 3: we do a little we do a little game in
Speaker 3: class where we'll have people stand up. You know, what
Speaker 3: de style do you fall in for your driving abilities?
Speaker 3: You know, are you in the bottom.
Speaker 2: Ten percent the top ten percent?
Speaker 3: And if you ask them, ninety five percent of the
Speaker 3: people think they're above average in their driving skills, So
Speaker 3: about forty five percent are seriously delusional. But we make
Speaker 3: the same thing with investing our investing ability.
Speaker 1: Yeah, and in fact, there are many many cognitive biases,
Speaker 1: and psychologists and neuroscience have gone through and named and
Speaker 1: identified us so many of these almost two hundred probably,
Speaker 1: but you point out several besides hindsight and over confidence,
Speaker 1: what are others that affect the way that people invest
Speaker 1: their money?
Speaker 3: One of the worst most destructive is hurting.
Speaker 2: Bias, as in h er D.
Speaker 3: Yeah, yeah, hurting, So, you know, great for Zebra, really
Speaker 3: bad for investors. And the psychology behind is that if
Speaker 3: everybody's doing it, it must be right and it must
Speaker 3: be safe.
Speaker 2: And that's how bubbles happen.
Speaker 3: If you look from like ninety five to two thousand,
Speaker 3: s and P five stocks made twenty two percent for
Speaker 3: five years in a row. Tech stocks made forty five.
Speaker 2: Years in a row.
Speaker 3: So everybody loaded up on tech stocks, loaded up on
Speaker 3: you know, based on this hurting bias if their friends
Speaker 3: are doing it. It's it's almost kind of immature, remember
Speaker 3: like high school, you know, where peer pressure. Everybody's doing
Speaker 3: it, it must be the right thing to do. And then
Speaker 3: people are left, you know, stunned when they lose textlocks
Speaker 3: lost seventy five percent of all their value. These these
Speaker 3: are these are not inconsequential results from these biases.
Speaker 2: They can be severe.
Speaker 1: Yeah, And one of the things that you mentioned that
Speaker 1: really struck me was this issue that no company is
Speaker 1: too big to fail.
Speaker 2: Yeah.
Speaker 3: So another bias that people have is familiarity bias. We
Speaker 3: mistakenly think that the things that we're familiar with are
Speaker 3: safe and our good investments. So every when I go
Speaker 3: around and do different speaking engagements, every town seems like
Speaker 3: it has its own, you know, familiar familiarity bias. In Cincinnati,
Speaker 3: where I used to live, it was Procter and Gamble.
Speaker 2: That was their home.
Speaker 3: And I had, you know, an investor some years ago.
Speaker 3: They were only six months from retirement and there I said,
Speaker 3: you know, you really should just put this in cash,
Speaker 3: wait till you retire and diversify it, because you have
Speaker 3: it all in one once thought, And the answer was,
Speaker 3: oh no, it's I worked there for thirty five years.
Speaker 2: I know the CEO.
Speaker 3: We're internationally diversified, and they knew the academics, which says diverse,
Speaker 3: five diversified, diversify. And six months later they had lost.
Speaker 3: They had a five million dollar portfolio. They lost two
Speaker 3: and a half million dollars. And just because they were familiar.
Speaker 3: I met a man recently in one of our classes
Speaker 3: with well tens of millions in Boeing, and he said, no,
Speaker 3: I'm not going to diversify.
Speaker 2: I know Boeing. I worked there for thirty years. I
Speaker 2: have all my money there, you know.
Speaker 3: And Boeing literally made an airplane that wrecked itself on
Speaker 3: the autopilot came on, and then they had doors flying
Speaker 3: off of their airplanes.
Speaker 2: And then they had violations.
Speaker 3: They had twenty billion dollars of contracts canceled. So what
Speaker 3: I what I tried to coach investors is no matter
Speaker 3: how safe you think that company is, no company is safe.
Speaker 3: No company by itself is impregnable, and.
Speaker 2: And any of them can go bankrupt.
Speaker 3: I know it sounds ludicrous to think Apple could go bankrupt,
Speaker 3: but eventually somebody will take Apple out.
Speaker 1: Yeah. What was the Dutch East India Company?
Speaker 2: Yeah, so it was the Dutch East India Company.
Speaker 3: They had they paid an eighteen percent, dived in for
Speaker 3: two hundred years, and they had their own army.
Speaker 2: They had their own warships, they had their own navy. Uh.
Speaker 3: And then in the seventeen hundreds they just went belly
Speaker 3: up and everybody lost all their money.
Speaker 2: Uh.
Speaker 3: It was bigger than Apple, bigger than Google, bigger than Tesla.
Speaker 2: Uh Uh it was. It was, for its.
Speaker 3: Time and for all age, the the largest company that
Speaker 3: ever existed.
Speaker 1: Right, And people felt at the time there's no possibility
Speaker 1: they were worth than modern dollars over a trillion, right,
Speaker 1: something like seven.
Speaker 2: Yeah, I mean just an incredible amount of value. Uh.
Speaker 2: And then they got they got killed.
Speaker 1: Right, so if they can go out of business, Apple
Speaker 1: could go out of business Google, any of these right
Speaker 1: when I when I grew.
Speaker 4: Up, the big one was, uh was Kodak and they
Speaker 4: had they had remember the drive up you know Kodak,
Speaker 4: you know thing where you get your pictures developed.
Speaker 3: And in one day and they even theyd they even
Speaker 3: invented the digital camera and the CEO said, no, we're
Speaker 3: not going to do that U because we're a paper
Speaker 3: and chemical company. They had ninety five percent of all
Speaker 3: the photo development, they had eighty five percent of all
Speaker 3: the cameras sold, and they went.
Speaker 2: And they went bankrupt.
Speaker 3: Same thing with Blockbuster Netflix Netflix for forty million dollars.
Speaker 3: Tried to get Blockbuster to buy them out, and Blockbuster said, no,
Speaker 3: we're not going to buy you out. You know we
Speaker 3: have we have fifteen hundred brick and mortar buildings and
Speaker 3: that's our business model.
Speaker 2: And of course they went under. Who got it? Okay?
Speaker 1: So foreign investor the idea that hey, everybody's investing in
Speaker 1: this company and it's safe, I should put my money
Speaker 1: in the Dutch East India company or whatever that can't
Speaker 1: that's not a good strategy. And in fact, by the way,
Speaker 1: even very smart people can go wrong here. So Isaac Newton,
Speaker 1: what did he invest in?
Speaker 3: So he he invested in the south Sea bubble, So
Speaker 3: you got Newton massive IQ obviously created discovered gravity, calculated
Speaker 3: the celestial movements through the dynamic laws of motion. But
Speaker 3: he got sucked in because all of his buddies were
Speaker 3: in it. Everybody was investing in the south Sea company.
Speaker 3: And he lost the equivalent of three million dollars in
Speaker 3: today's dollars. And it's not just the money, it's the
Speaker 3: emotional toll that it takes on people. And he too,
Speaker 3: his dying day regretted and had remorse and sadness over
Speaker 3: the fact that he had squandered so much of his wealth.
Speaker 2: And I call this attribution error.
Speaker 3: We think that because we're really good in one thing,
Speaker 3: that skill must transfer to another thing, and especially in investing,
Speaker 3: people think, well, I'm a brain surgeon or I'm a
Speaker 3: neuroscientist or whatever, so you know, I'm going to automatically
Speaker 3: be good at this other thing.
Speaker 2: But I give him the example. No one would if
Speaker 2: you had.
Speaker 3: You know, those movies where the pilots of the plane
Speaker 3: get some kind of stomach problem or whatever, and they
Speaker 3: get this, you know, incapacitated, and they ask for someone
Speaker 3: to come and fly the plane, and then a passenger
Speaker 3: lands the plane. I looked up to statistics. That has
Speaker 3: never happened, not one single time. And if you ask
Speaker 3: pilots what are the odds of that happening, they are zero.
Speaker 3: There is no chance of a person that's not trained
Speaker 3: to land it. But if you ask men could they
Speaker 3: do it? Fifty percent of all men say they could
Speaker 3: land that plane. Yeah, overconfidence and attribution error.
Speaker 1: And what about the necessary lie bias?
Speaker 3: Oh my gosh, this one has massive application, not only
Speaker 3: to investing. So it's the thing that you do, uh,
Speaker 3: before you do something that's imprudent. It's a lie that
Speaker 3: you tell yourself to allow you to do it even
Speaker 3: though you know you shouldn't. So it's like okay, for
Speaker 3: an alcoholic, well just won't one won't hurt, you know,
Speaker 3: one drink won't hurt. Or for a gambler and they're
Speaker 3: in Vegas, well they're down twenty thousand dollars, but I'll
Speaker 3: stop when I get I get I get even, or
Speaker 3: you know, fitness area. You know, I'll you know, I
Speaker 3: really want to lose thirty pounds, but that piece of
Speaker 3: looks really good.
Speaker 2: I'll start my diet tomorrow.
Speaker 3: So it allows a person to take an imprudent behavior
Speaker 3: and justify it with a lie.
Speaker 2: And get away with it. Oh boy.
Speaker 1: And so we're yoked with all these biases. They steer
Speaker 1: our behavior. Even though we tend to think we're like
Speaker 1: mister Spock and Star Trek, we're not at all. And
Speaker 1: every bias comes with a story, right.
Speaker 3: Yeah, it all, It all comes with the story, you know.
Speaker 2: It's it's it's interesting to watch people.
Speaker 3: One of the stories people have and it is the
Speaker 3: perception that they're in control of their thinking. And this
Speaker 3: is one of the exercises in the workshop. I write
Speaker 3: about on the book that we really don't have as
Speaker 3: much control as we think we do. And I got
Speaker 3: a lot of this from your book, you know, but
Speaker 3: for investors, they really feel like they have control.
Speaker 2: And we do a couple exercises.
Speaker 3: One is, you know, for thirty seconds, close your eyes
Speaker 3: and don't think of anything, no self talk, no you know,
Speaker 3: And if people are honest, at the end of the
Speaker 3: thirty seconds, almost everybody has to raise their hand that
Speaker 3: you know, their internal internal voice came back. So I said, well,
Speaker 3: if you can't control even you can't even stop it.
Speaker 3: You're definitely not in control of that inner voice. And
Speaker 3: then it also shows up. It doesn't show up like
Speaker 3: a cheerleader when you wake up in the morning, I'm
Speaker 3: going to take on the.
Speaker 2: Day and I'm going to create unbelievable things.
Speaker 3: It's more like e or oh no, another day, and
Speaker 3: I should work out, but it's raining.
Speaker 2: I think we'll have a donut.
Speaker 3: So and then we talk to ourselves, and that's a
Speaker 3: bizarre thing in itself.
Speaker 2: We debate ourselves and talk to ourselves.
Speaker 3: Who's the person doing the talking and who's the person
Speaker 3: doing the listening. And so people they feel like they
Speaker 3: have all this control over their behavior and actions and investing,
Speaker 3: and the reality is they just don't.
Speaker 2: Okay.
Speaker 1: So we talked about some biases, but even really basic
Speaker 1: stuff like how an investor understands what is meant by
Speaker 1: their average return? What's an example of the way that
Speaker 1: that gets manipulated.
Speaker 3: First of all, most investors have no idea what they've
Speaker 3: actually earned or didn't earn over the last thirty years.
Speaker 3: The best way to cowlate a rate of return is
Speaker 3: time weighted and dollar weighted compound return.
Speaker 2: And I don't expect anyone to understand any of that,
Speaker 2: but what I will say is that it's very easy.
Speaker 3: To misunderstand your rate of return. So let's say you
Speaker 3: have an investment, because most people calculate their average rate
Speaker 3: of return.
Speaker 2: So let's say you start with.
Speaker 3: One hundred thousand, and you get one hundred percent in
Speaker 3: one year, and it goes up to two hundred thousand,
Speaker 3: and then the next year you lose fifty percent and
Speaker 3: it goes back down to one hundred thousand. Well, the
Speaker 3: average rate of return is twenty five percent because you've
Speaker 3: got one hundred minus fifty, which leaves you fifty divided
Speaker 3: by two, which is twenty five percent.
Speaker 2: But your real rate of return is zero.
Speaker 3: And investors try to calculate their average rate of return,
Speaker 3: but it's widely inaccurate and so so that just leads
Speaker 3: to the overconfidence bias and all the other biases as well.
Speaker 3: But in addition to the biases, investors also have to
Speaker 3: deal with their instincts.
Speaker 2: And instincts are for in life.
Speaker 3: A lot of times they give you great signals like
Speaker 3: if I'm out in the water and someone y'all's shark
Speaker 3: and my instinct is to go in, that's, you know,
Speaker 3: probably not a bad instinct. But they're driven by pleasure
Speaker 3: and pain. So some things are pleasurable, Like maybe I
Speaker 3: like chocolate covered peanuts, and if I have a small,
Speaker 3: little handful, fine, But if I eat all who half
Speaker 3: whole half pound bag of peanuts, bad news, chocolate covered peanuts,
Speaker 3: I'm gonna get fat on a cholesterol gonna you know,
Speaker 3: die eventually.
Speaker 2: Same thing with pain.
Speaker 3: Some you know, a lot of people will say exercise
Speaker 3: is painful, and maybe for some people it is, but
Speaker 3: it could also save your life.
Speaker 2: Well, investing instincts are all always wrong.
Speaker 3: When you lose some thirty percent in your equities, that's pain,
Speaker 3: and people want to leave, they want to run, they
Speaker 3: sell it, they go to whatever is high, and they're
Speaker 3: always doing the exact opposite of what they should do.
Speaker 3: They're chasing high returns, they're panicking when things go down,
Speaker 3: and so the instincts are deadly for investors and they
Speaker 3: run in the background and they don't even realize it's happening.
Speaker 1: So what did you learn from the academics about investing.
Speaker 3: The first thing I learned from the academics, and the
Speaker 3: only reason I was willing to accept what they had
Speaker 3: to say, was that I had done the speculating and gambling.
Speaker 3: I actually was part of the problem. I was with
Speaker 3: a broker dealer. They were telling me try to pick
Speaker 3: the best stocks. They were telling me they could time
Speaker 3: the market and get in and out. They were telling
Speaker 3: me they had these great managers that could beat the market.
Speaker 3: And I was investing my money that way, my family's money,
Speaker 3: my client's money, and it wasn't working. And I went
Speaker 3: to the broker dealer and I said, hey, this is broken.
Speaker 3: This is people are getting hurt. And the president of
Speaker 3: the broker dealer said, so what, just sell them something else.
Speaker 2: What's your problem?
Speaker 3: So I heard a debate between Donald Jackman of five
Speaker 3: Star Money Management in Rex Singfeld, who had studied under
Speaker 3: Eugene Fama at the University of Chicago, who's now a
Speaker 3: Nobel Prize winner, and they taught me about.
Speaker 2: Efficient market theory.
Speaker 3: An efficient market theory means that the returns don't come
Speaker 3: from great managers. The returns come from asset classes or
Speaker 3: categories based on the cost of capital, which means a
Speaker 3: company that is more risk long term should have a
Speaker 3: higher return because they have a higher cost of raising
Speaker 3: capital to fund their company. And so if you look historically,
Speaker 3: things like large stocks historically around ten percent, small stocks
Speaker 3: historically twelve percent, small value stocks fourteen percent. So the
Speaker 3: return comes from the market, not the manager. So the
Speaker 3: first job is to eliminate gambling and then focus on
Speaker 3: the academics to develop a portfolio with the highest expector
Speaker 3: return in the lowest amount of volatility. And David, I've
Speaker 3: I've been teaching financial advisors about this for thirty four years.
Speaker 2: And they still don't get it.
Speaker 3: And it's really it's a sad thing, and it's tragic
Speaker 3: because a lot of people say they do it, but
Speaker 3: then their own biases, the advisors biases, and their instincts
Speaker 3: and their emotions take over and it destroys the process.
Speaker 1: Ough, So what are the lessons that come out of
Speaker 1: you look at all this stuff, the Nobel laureates and
Speaker 1: economic and the things they discover, the lessons they learn.
Speaker 1: How do you summarize all that?
Speaker 2: The first thing is.
Speaker 3: Most people, the way they relate to their money, especially
Speaker 3: their portfolios, is through speculating and gambling, and they don't
Speaker 3: really mind because they don't really have a purpose for
Speaker 3: their money that they've acknowledged and they focus on. So
Speaker 3: in the lack of focusing on a purpose, the default
Speaker 3: position is just.
Speaker 2: Getting more money.
Speaker 3: Now, the problem with just getting more money is that
Speaker 3: just getting more money can't make you happy. As a
Speaker 3: matter of fact, as a practitioner working with thousands of people,
Speaker 3: actually getting more money can have the opposite effect. It
Speaker 3: creates more doubt, more fear, more responsibility, jealousy within the family,
Speaker 3: more stress and anxiety about how you're going to invest
Speaker 3: it or what you're gonna do with it. So money
Speaker 3: does not make you happy, and you can think about
Speaker 3: people like Howard Hughes and Elvis Presley and Marilyn Monroe. Obviously, money,
Speaker 3: power and fame doesn't equal happiness. And the reason it
Speaker 3: doesn't is because you might get that temporary thrill from
Speaker 3: that new car or that piece of jewelry or that
Speaker 3: new house, but it's temporary in nature and is not lasting.
Speaker 3: But that's what keeps people gambling with their money because
Speaker 3: they figure if they can take their million and turn
Speaker 3: it into two million, they'll all of a sudden be happy.
Speaker 2: Well, it's not true.
Speaker 3: And I discovered that when I was twenty seven working
Speaker 3: with investors. So I spend my whole life trying to
Speaker 3: help people build their money, and then the net result.
Speaker 2: Is no happiness. It's like, wow, this is darable.
Speaker 3: So one of the things we do is we help
Speaker 3: people break through the no talk rule, because people have
Speaker 3: terrible shame and guild about money also, and they often
Speaker 3: learn the no talk rule about it from their parents,
Speaker 3: and so breaking through.
Speaker 1: That no talk deals the no talk rule is yeah,
Speaker 1: so the no talk.
Speaker 2: Rule is that.
Speaker 3: And usually in families there's there's a no talk rule
Speaker 3: about the no talk rule.
Speaker 2: Uh So, so.
Speaker 3: You know, the next door neighbor gets a new car
Speaker 3: and Johnny says to Mom, well, I wonder how much
Speaker 3: that car cost. I'm gonna go ask them, And they're like,
Speaker 3: don't you do that. Don't you dare ask somebody what
Speaker 3: their car costs? You know, that's that's impolite, that's rude.
Speaker 3: We don't talk about stuff like that. And and so
Speaker 3: normally if you look at look at things that people
Speaker 3: won't talk about, it's usually because they feel shame and
Speaker 3: guilt around it. And so then there's this this this
Speaker 3: the stigma about talking about money, and it's very destructive.
Speaker 3: And people are taught that if you're going to invest,
Speaker 3: you do it alone, either isolated by yourself on a computer,
Speaker 3: or maybe just with one other advisor. It's never ever
Speaker 3: thought of, maybe we should do this as a community,
Speaker 3: have a class in training and workshop and people could
Speaker 3: talk about their life and their money and their experience,
Speaker 3: which I found is actually the most the most powerful
Speaker 3: way so the in the without a lack of purpose,
Speaker 3: then people are are thrown to investing, picking timing, and
Speaker 3: then today you have all these toxic investments like bitcoin
Speaker 3: that people get sucked into gambling with and they it
Speaker 3: in a lot of areas of life. You can make
Speaker 3: a single mistake if you've lost forty pounds and you
Speaker 3: go have a piece of cheesecake at dinner. Okay, fine,
Speaker 3: you're probably not going to have a heart attack that night.
Speaker 3: That's not how investing works. You can make one mistake
Speaker 3: on anyone given day and you can wipe out forty
Speaker 3: five years of hard work and investing. And that's what
Speaker 3: makes all these biases so critical. And if the instincts
Speaker 3: and the biases weren't enough then you also have to
Speaker 3: deal with emotion. So you have this cocktail of emotions, instincts,
Speaker 3: and biases whip sawing you all over the place as
Speaker 3: an investor with no academic understanding of how markets really work,
Speaker 3: and you.
Speaker 2: Can see how it can be so dangerous for people.
Speaker 1: Excellent, by the way, I think, I want to step
Speaker 1: back on one point though, What were the five discoveries
Speaker 1: that you were able to summarize that of.
Speaker 2: All this, Yeah, so.
Speaker 3: Discovery number one. Stock picking in all of its forms
Speaker 3: is destructive behavior. Now, when I coach the coach people
Speaker 3: on this stuff, they have a massive amount of cognitive
Speaker 3: dissonance because they've been doing it for twenty or thirty years,
Speaker 3: so when they first hear it's jarring. So stock picking
Speaker 3: in all of its forms is destructive behavior. Market timing
Speaker 3: trying to get in and out of the market at
Speaker 3: the best timing. That's destructive behavior. It actually increases risk
Speaker 3: invariance in a portfolio. Track record investing trying to find
Speaker 3: the manager that beat the market in the past with
Speaker 3: the hopes that they'll continue to do it in the future.
Speaker 3: Destructive behavior for most experienced investors that have been around
Speaker 3: for a while. I have done one or more of
Speaker 3: these behaviors in the past, and left to my own devices,
Speaker 3: will repeat them without a disciplined discipline coach to help
Speaker 3: me through it. And then finally the Koudo gra I
Speaker 3: always tell people, if you can get this one, you
Speaker 3: automatically get the other ones. It is abjectly absurd to
Speaker 3: speculate and gamble with my money, especially once I've created
Speaker 3: a purpose that's greater than money itself. And those are
Speaker 3: the five discoveries from the academic research that I've been
Speaker 3: able to work with these researchers over the last thirty
Speaker 3: four years.
Speaker 1: You talked about this thing where you ask people to
Speaker 1: pick three stocks that they want to invest in, So
Speaker 1: tell us about that.
Speaker 3: So in the class, I was trying to think of away,
Speaker 3: because you go through these biases, and we have exercises
Speaker 3: and we take people through the biases and the emotions
Speaker 3: and the instincts and the whole thing, say familiarity bias,
Speaker 3: size bias, hindsight bias, hurting bias. And I was trying
Speaker 3: to think, how can I have an example of this working.
Speaker 3: So I have people write down three stocks, write down
Speaker 3: three stocks, and then I and then I have them
Speaker 3: stand up and I read off the five biggest stocks Amazon, Tesla, Meta, Facebook.
Speaker 2: In NA video.
Speaker 3: And when I'm done reading off the list of the
Speaker 3: biggest five, ninety five percent of the people are standing.
Speaker 2: And I said, guys, I just went over there. There
Speaker 2: are over twenty thousand stocks in the US market. You
Speaker 2: could buy.
Speaker 3: Twenty thousand, and you guys still picked the top only five.
Speaker 3: And I tell them it's because you didn't pick the stocks.
Speaker 3: The stocks picked you through your screens and your biases.
Speaker 3: All you could see, even though I spent a day
Speaker 3: and a half.
Speaker 2: Teaching you about this stuff, you.
Speaker 3: Still picked the biggest ones you're the most familiar with
Speaker 3: that are hurting and everybody else is doing the exact
Speaker 3: same thing.
Speaker 2: Right. But now, why is that a problem?
Speaker 1: Because you might say, look, you know what's the problem
Speaker 1: with hurting if I go for this big stock.
Speaker 2: Yeah, the problem is you're not diversified.
Speaker 3: And when we analyze portfolios, I call them Frankenstein portfolios.
Speaker 3: They might have an index fun here and there, then
Speaker 3: they have some active managers and then they're loaded up
Speaker 3: on those.
Speaker 2: Top five stocks.
Speaker 3: And the problem is number Since we discussed that number one,
Speaker 3: any company can fail. I remember two thousand and eight
Speaker 3: to two thousand and nine, trillions of dollars disappeared in
Speaker 3: companies like Enron, WorldCom. Everybody had all their money in
Speaker 3: those big companies. They thought they were a bulletproof. Even
Speaker 3: GM went bankrupt in two thousand and eight. In two
Speaker 3: thousand and nine, so you know, the problem is you
Speaker 3: have massive amounts of risk without any expected additional return
Speaker 3: versus for that part of your portfolio. Maybe you're gonna
Speaker 3: put fifteen percent in large companies. You could just own
Speaker 3: the S and P five hundred and I'll own all
Speaker 3: five hundred, not you know, playing Russian roulette by picking
Speaker 3: out just five and so the damage is, you know,
Speaker 3: like like Newton and showing this. Newton thought he had
Speaker 3: it figure it out too. He was stock picking, he
Speaker 3: was market timing, he was tracked record investing. And I
Speaker 3: don't think anybody in my class is smarter than Newton.
Speaker 1: But it's more than that, isn't it, Because the return
Speaker 1: on those big stocks is much less than the return
Speaker 1: on other stocks in the market as well. Right In
Speaker 1: other words, once you know, hey, everyone's talking about X,
Speaker 1: and you buy it, then it's then it's too late already.
Speaker 3: Yeah, if you look at let's say that you loaded
Speaker 3: up on seven. They call it the Magnificent seven, and
Speaker 3: you're referring to a graph in the book. It says, well, okay,
Speaker 3: these magnificent seven in hindsight, which you can't go back
Speaker 3: in a time machine and buy now. In hindsight, they
Speaker 3: made twenty two percent higher return than the market hypothetically
Speaker 3: over the last three years. So everybody is based on
Speaker 3: recency bias. Another one we didn't talk about yet. Based
Speaker 3: on the recent performance just over the last three years,
Speaker 3: everybody extrapolates that out and says, oh, they're going to
Speaker 3: continue to beat the market the way they have over
Speaker 3: the last three years. But the graph in the book
Speaker 3: shows that on average over the next ten years, those
Speaker 3: stocks that got hot underperform the market dramatically over the
Speaker 3: next ten years. So that three year you can't go
Speaker 3: back at a time machine and buy those three years,
Speaker 3: and if you chase those returns, chances are you'll dramatically
Speaker 3: underperform the market.
Speaker 1: So tell us about the importance of decision control systems.
Speaker 3: We talk about algorithms, and you can have an algorithm
Speaker 3: of how to take all this academic information and build
Speaker 3: portfolios and that's absolutely required. And in addition to that,
Speaker 3: most people don't think of algorithms as something that control
Speaker 3: human behavior. But if you only have one piece of
Speaker 3: the pie, you can have a great engineered portfolio, just
Speaker 3: like you could have a great engineer diet, or you
Speaker 3: could have a great engineered workout program. But if you
Speaker 3: don't have the decision control system that then helps you
Speaker 3: stay committed to that process and discipline over long periods
Speaker 3: of time, it'll fail every single time. So you have
Speaker 3: to have a way to manage your own behavior because
Speaker 3: investing is so easy to destroy the behavior. Even if
Speaker 3: I gave you the perfect mix of the portfolio and
Speaker 3: you went online you bought the mix of the assets.
Speaker 3: Right next to that perfect portfolio is a button that
Speaker 3: you can click on on your cell phone to sell
Speaker 3: it and destroy it or add garbage to it like
Speaker 3: bitcoin or gold er, you know, some exotic new thing
Speaker 3: that comes out. So it is critical to have a
Speaker 3: decision control system to manage and control for human behavior.
Speaker 3: And without that, I've discovered over the last forty years
Speaker 3: the process almost always fails. So what is your decision
Speaker 3: control system? So first of all, I have to I
Speaker 3: have to my wife or mind's myths not always easy
Speaker 3: for me. I have to be humble, and I have
Speaker 3: to recognize what I can do and what I can't do,
Speaker 3: and not live in a fantasy world where I think
Speaker 3: I can predict the future. So I have to have
Speaker 3: people like Eugene Fauma and Nobel Prize winner and Harry Markowitz,
Speaker 3: people like you that remind me that I'm limited in
Speaker 3: my human behavior and that my instincts and emotions could
Speaker 3: take over unless I protect against it. So I defer
Speaker 3: to the academics, and I defer to proof, scientific proof,
Speaker 3: and then I have to stay disciplined no matter what.
Speaker 3: Two thousand and eight, two thousand and nine, the S
Speaker 3: and P drop fifty percent, and investors were begging sell, sell, sell,
Speaker 3: get me out, get me out. It would be easy
Speaker 3: to cave in for a money manager. I've seen sow
Speaker 3: many that did it, to cave into what the investor
Speaker 3: wanted at the time. But we get paid to keep
Speaker 3: people disciplined, not to cave into their instincts, emotions and biases,
Speaker 3: staying true to that. And then for the investor and
Speaker 3: the advisors, you have to create education, workshops, exercises.
Speaker 2: And constant reinforcement.
Speaker 3: Without that constant reinforcement and repetition over and over and
Speaker 3: over again, people will fail at the exact wrong time
Speaker 3: when the stress and anxiety are the highest. So it's
Speaker 3: a whole it's a whole process that people need to
Speaker 3: follow if they're going to help, if they're going to
Speaker 3: have any hopes of staying discipline over a thirty year period,
Speaker 3: which is what it takes to be an investor.
Speaker 2: That was Mark.
Speaker 1: Madson, who runs Matts and Money and has a new
Speaker 1: book out called The American Dream. Now, I just want
Speaker 1: to pick up one point he made about having a
Speaker 1: decision control system, in other words, some way to bind
Speaker 1: your decision making. There are many ways to do this.
Speaker 1: My favorite is the Ulysses contract, which I covered in
Speaker 1: episode nine, so very briefly. You may remember the story
Speaker 1: in the Odyssey, the Greek legend, the hero of the
Speaker 1: Trojan War, Ulysses, is returning home after the war's end
Speaker 1: when he realizes that his ship is going to pass the.
Speaker 2: Island of the Sirens.
Speaker 1: And this presents a wild opportunity because the Sirens are
Speaker 1: known for their mesmerizingly beautiful songs. But these songs are
Speaker 1: so enchanting that they hypnotize any sailors who hear them,
Speaker 1: which causes the sailors to steer their ships towards the
Speaker 1: island and they inevitably crash into the rocks and die.
Speaker 1: And Ulysses knew that he, like any other mortal, would
Speaker 1: be powerless against the sirens song, and he was going
Speaker 1: to meet the same fate if he heard those songs.
Speaker 1: But he really wanted to hear the songs, so he
Speaker 1: devised a plan. He ordered his men to tie him
Speaker 1: to the mast of the ship with ropes, and he
Speaker 1: told them, no matter how much I scream or beg
Speaker 1: or cry, just keep rowing whatever I knew, just keep rowing.
Speaker 1: And then he had his men fill their ears with
Speaker 1: beeswax to block out the sirens song. So he did
Speaker 1: this while they were still far from the island. And
Speaker 1: this was a rational move because he knew that the
Speaker 1: future Ulysses, once they were close to the island, would
Speaker 1: be impulsive and would be unable to resist.
Speaker 2: His short term desires.
Speaker 1: And so, understanding this danger, the rational Ulysses at a
Speaker 1: distance set up safeguards to prevent his future self from
Speaker 1: making a fatal mistake. This was a contract between his
Speaker 1: present self and his future self. His present self who
Speaker 1: was rational, and his future self who was crazed with desire.
Speaker 1: He thought clearly about how he was going to act
Speaker 1: in that future scenario, and he created barriers to protect
Speaker 1: himself from.
Speaker 2: His own behavior.
Speaker 1: So this type of decision where we willingly create constraints
Speaker 1: to bind our future actions, that's what's known as a
Speaker 1: Ulysses contract. It's a pre commitment strategy where you do
Speaker 1: something now to bind yourself to some course of action
Speaker 1: that you know is a good move, but you know
Speaker 1: that your future self isn't going to want to do so.
Speaker 1: In investing, you can set up Ulysses contracts with yourself
Speaker 1: to prevent emotional decision making that leads to a lowsy outcomes.
Speaker 1: There are lots of ways people do this in investing.
Speaker 1: A simple one is automated investments. You set up automatic
Speaker 1: contributions to your investment account and automatic buys of say
Speaker 1: an index fund like the S and P five hundred,
Speaker 1: and then you just sit back and know that this
Speaker 1: is running in the background. This way, you don't need
Speaker 1: to be involved with your ongoing biased decision making, and
Speaker 1: this avoids the temptation to skip contributions when mar kids
Speaker 1: are volatile, or when you feel the itch to spend
Speaker 1: your money elsewhere. You can also set up pre defined
Speaker 1: rules for selling investments. You can set up orders that
Speaker 1: sell a stock if it drops to a certain price
Speaker 1: or hits some predetermined gain, and that prevents the temptation
Speaker 1: to hold on to investments too long or selling too soon.
Speaker 1: This is not an investing podcast, so I'm not gonna
Speaker 1: go into detail on any of this, but you can
Speaker 1: make diversification commitments and then make sure you stick to
Speaker 1: that allocation as a Ulysses contract, and that prevents you
Speaker 1: from overly concentrating in one asset. And depending on your circumstances,
Speaker 1: you can even build barriers to accessing your investment accounts easily.
Speaker 1: Some people will use financial advisors or a separate investment
Speaker 1: platform that requires a lot of effort to make changes.
Speaker 1: And this is something on the opposite end of the
Speaker 1: spectrum from these apps that make it effortless to buy
Speaker 1: and sell stocks like you're playing a video game. Anyway,
Speaker 1: whatever you put into place, this simple idea behind you.
Speaker 1: Lissi's contract is to create systems that prevent bad decision making,
Speaker 1: or emotional decisions or impulsive decisions, and that's probably the
Speaker 1: smartest thing we can do keep our moment to moment
Speaker 1: psychology out of these sorts of decisions. So that's the
Speaker 1: main takeaway lesson from today from the point of view
Speaker 1: of neuroeconomics. No matter how smart you are in other areas,
Speaker 1: there are many influences under the hood that badly bias
Speaker 1: your decision making. So go out and have fun and
Speaker 1: do whatever you want, but figure out what you need
Speaker 1: to do to avoid the sirens song so that you
Speaker 1: can have smooth sailing into the future. Thanks for joining
Speaker 1: me on this journey into our minds. If you enjoyed it,
Speaker 1: don't forget to subscribe. Go to eagleman dot com slash
Speaker 1: podcast for more information and to find further reading, and
Speaker 1: check out and subscribe to Inner Cosmos on YouTube for
Speaker 1: videos of each episode and to leave comments. Until next time,
Speaker 1: stay curious. I'm David Eagleman, and we have been sailing
Speaker 1: through the inner cosmos.