WEBVTT - At the Money: Behavior For Better Investing

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<v Speaker 1>To day to strength to day. If you could change

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<v Speaker 1>only one thing that would help your investing, what would

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<v Speaker 1>it be? The answer? Your own behavior. We humans are

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<v Speaker 1>a mess of biases and poor decision making. We only

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<v Speaker 1>read or watch things we agree with. We forget our

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<v Speaker 1>worst trades, and we allow our emotions to get the

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<v Speaker 1>best of us. We are filled with unjustified overconfidence in

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<v Speaker 1>our own abilities. As it turns out, when it comes

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<v Speaker 1>to investing, we are our own worst enemies. I'm Barry

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<v Speaker 1>Riddelts and on today's edition of At the Money, we're

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<v Speaker 1>going to discuss how to best manage our own behavior

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<v Speaker 1>for the health of our portfolios. To help us unpack

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<v Speaker 1>all of this and what it means for your portfolio,

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<v Speaker 1>let's bring in doctor William Bernstein. He is both a

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<v Speaker 1>neurologist and a professional investor. He is the author of

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<v Speaker 1>numerous books on investing, perhaps most famously The Four Pillars

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<v Speaker 1>of Investing Lessons for Building a Winning Portfolio. So Bill,

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<v Speaker 1>let's start with a simple observation from your research. When

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<v Speaker 1>it comes to making risk allocation decisions in capital markets,

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<v Speaker 1>we just ain't built for it.

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<v Speaker 2>Explain well, Barry, our late places scene ancestors evolved in

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<v Speaker 2>an environment with a risk horizon that was measured in seconds,

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<v Speaker 2>sometimes fractions of a second, whereas in the modern era

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<v Speaker 2>our financial risk arise and extends a half a century

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<v Speaker 2>or so. So, in short, we are living in this

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<v Speaker 2>space age with stone Age brains.

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<v Speaker 1>So let's delve into those stone Age brains and how

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<v Speaker 1>its evolutionary development leads us Australia in modern capital markets.

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<v Speaker 1>What is it that our wetwear does to us?

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<v Speaker 2>Well? My favorite analogy is what I call the skunk analogy,

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<v Speaker 2>which is over the past ten or twenty million years,

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<v Speaker 2>skunks of all a very effective strategy for dealing with

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<v Speaker 2>large predators, which was to turn one hundred and eighty degrees,

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<v Speaker 2>lift their tails, and spray. And that's very effective until

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<v Speaker 2>they find themselves in a semi of environment where the

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<v Speaker 2>biggest threat to their existence is a two ton hunk

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<v Speaker 2>of steel moving at sixty miles an hour. That is

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<v Speaker 2>exactly the wrong strategy. It's the same way with investing.

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<v Speaker 2>When we mess up and we want to distance ourselves

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<v Speaker 2>from our mistakes, we panic and we sell, which most

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<v Speaker 2>of the time is the wrong response.

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<v Speaker 1>I love this quote of yours to the extent you

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<v Speaker 1>succeed in finance, you succeed by suppressing the limbic system,

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<v Speaker 1>the very fast moving emotional system. If you cannot suppress that,

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<v Speaker 1>you're going to die poor. Explain that to us.

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<v Speaker 2>Well, our system one, that is our crew be speaking.

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<v Speaker 2>Our repilian brain is where our fear and our greed live.

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<v Speaker 2>So to give you a simple example, we evolve to

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<v Speaker 2>think well of ourselves and to feel shame and discussed

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<v Speaker 2>when we fail, which is a very effective evolutionary strategy

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<v Speaker 2>in the late place to seem environment. And unfortunately, when

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<v Speaker 2>we make a mistake in investing, we buy a sinco asset,

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<v Speaker 2>we try to distance ourselves from it by selling in

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<v Speaker 2>a panic. Now, the level of individual security is that

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<v Speaker 2>may or may not be an effective response, but at

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<v Speaker 2>the asset class level, it's generally best when you buy

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<v Speaker 2>a bad acid class to either hold firm or to

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<v Speaker 2>buy more.

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<v Speaker 1>So let's get into some more details about that you observe.

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<v Speaker 1>The single most important determinant of one's long term success

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<v Speaker 1>is one's behavior during the worst two percent of markets.

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<v Speaker 1>Why is that, Well.

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<v Speaker 2>You can think of investing metaphorically as a highway on

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<v Speaker 2>which you drive your assets from your present self to

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<v Speaker 2>your future self, and most of the time the driving

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<v Speaker 2>is pretty smooth, the road is pretty good. But occasionally

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<v Speaker 2>they'll suddenly run into a massive pothole or a blind

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<v Speaker 2>curve on a dangerous mountain pass with no guardrail, and

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<v Speaker 2>that's the worst two percent of the time. So in general,

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<v Speaker 2>the slower you drive, that is, the more conservative your portfolio,

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<v Speaker 2>the more likely you are to convey those assets from

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<v Speaker 2>your present self to your future self, that is, to

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<v Speaker 2>complete the journey. And the message there is to invest

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<v Speaker 2>more conservatively than you think you should, because two percent

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<v Speaker 2>of the time it'll prevent you from bailing from the

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<v Speaker 2>very effective long term strategy.

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<v Speaker 1>So let's talk a little more about that two percent.

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<v Speaker 1>I imagine the worst times for investor behavior is either at

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<v Speaker 1>the very top of a bubble where people have a

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<v Speaker 1>tendency to have pharmo and pile in, or at the

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<v Speaker 1>very bottom of a market correction or crash, where people

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<v Speaker 1>panic and capitulate and just dump everything of the lows.

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<v Speaker 1>What's your experience been.

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<v Speaker 2>My experience is the bottoms. That's more important. When I

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<v Speaker 2>talk about the worst two percent of the time, I'm

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<v Speaker 2>talking about you know, two thousand and eight, two thousand

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<v Speaker 2>and nine. I'm talking about nineteen seventy three, nineteen seventy four,

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<v Speaker 2>or nineteen thirty one nineteen thirty two, if you're familiar

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<v Speaker 2>with that history. Compounding is magic, but you have to

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<v Speaker 2>observe Charlie Munger's prime directive of compounding, which is to

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<v Speaker 2>never interrupt it. So that's what you're trying to prevent.

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<v Speaker 2>You're trying to prevent yourself from interrupting the magic of compounding.

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<v Speaker 2>And you do that by paying attention to the worse

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<v Speaker 2>two percent of the time and to design your portfolio

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<v Speaker 2>with that worse two percent of the time in mind.

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<v Speaker 1>Very interesting. So let's talk about one of the other

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<v Speaker 1>issues that overconfidence seems to lead to, and that's glamor stocks.

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<v Speaker 1>People seem to be seduced by these. It used to

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<v Speaker 1>be Amazon, then it was Apple, then Tesla, today it's Nvidia.

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<v Speaker 1>Why are we so taken by these household names that

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<v Speaker 1>have had tremendous run ups in the market.

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<v Speaker 2>Well, the economic historian Charlie Kindelberger said it best about

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<v Speaker 2>a half century ago, which is, there's nothing so disturbing

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<v Speaker 2>to one's well being in judgment as to see a

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<v Speaker 2>friend get rich. And that's the problem with glamor stocks.

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<v Speaker 2>Put another way, the history of stocks, the stocks of

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<v Speaker 2>companies with revolutionary technologies that sell it stratospheric multiples. It's

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<v Speaker 2>not unhappy history. Generally you wind up not doing terribly

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<v Speaker 2>well when you do that.

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<v Speaker 1>Another quote of yours that I love, the advent of

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<v Speaker 1>free trading is like giving chainsaws to toddlers.

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<v Speaker 2>Explain well, in the first place, commission free trading can

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<v Speaker 2>be an advantage, just like a chainsaw can be a

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<v Speaker 2>marvelous tool if you use it properly. So how do

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<v Speaker 2>you use the chainsaw of free trading and low expenses

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<v Speaker 2>effectively and safely? Well you do it by buying and

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<v Speaker 2>holding low cost EPs an index funds. How do you

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<v Speaker 2>use free trading improperly like a toddler with a chainsaw, Well,

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<v Speaker 2>you trade stocks and even worse options all day long.

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<v Speaker 2>If you're trading options all day long on a free platform,

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<v Speaker 2>your wealth is going to melt like Iceland a hot pavement.

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<v Speaker 1>So let's talk a little bit about that over confidence.

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<v Speaker 1>Do most of us really believe we're smarter than the market.

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<v Speaker 1>Do we really think we're stock picking or market timing geniuses?

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<v Speaker 2>Yeah, we sure as heck do that whenever you trade

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<v Speaker 2>a stock, you're saying you're smarter than the person on

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<v Speaker 2>the other side of the trade, which is generally not true.

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<v Speaker 2>And when you think that you can time the market,

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<v Speaker 2>you're saying that you're smarter than the collected wisdom of

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<v Speaker 2>the market, which is not true. You know more than

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<v Speaker 2>ninety percent of the time. And if that's not over confidence,

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<v Speaker 2>I don't know what is. But there's an overconfidence that's

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<v Speaker 2>even worse than the overconfidence of stock picking and market timing,

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<v Speaker 2>and that's over confidence about your risk tolerance. At the

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<v Speaker 2>top of the market, everyone's a long term investor, and

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<v Speaker 2>they don't take to heart my favorite quote from Fred

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<v Speaker 2>Schweed's marvelous book, Where the Customer's Yachts, which is that

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<v Speaker 2>there are certain things that cannot be adequately explained to

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<v Speaker 2>a virgin, either by words or pictures, Nor can any

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<v Speaker 2>description I might offer here even approximately what it feels

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<v Speaker 2>like to lose a real chunk of money that you

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<v Speaker 2>use to own. And that's what you run into when

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<v Speaker 2>you're overconfident about your ability to tolerate risk.

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<v Speaker 1>To say the very least. So there are a couple

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<v Speaker 1>of other things in some of your books that really

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<v Speaker 1>stood out when it came to human psychology, and one

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<v Speaker 1>of the things that jumped out was, very often we

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<v Speaker 1>rely on conventional wisdom. When the conventional wisdom is very

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<v Speaker 1>often wrong. How does conventional wisdom lead us astray?

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<v Speaker 2>Well, the conventional wisdom at a general sense is very

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<v Speaker 2>often right. Conventional conventional market wisdom that you need to

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<v Speaker 2>diversify to keep your expenses down, and there's a connection

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<v Speaker 2>between risk and return. Those are all generally true. But

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<v Speaker 2>where conventional wisdom falls down is when it comes to

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<v Speaker 2>specific securities. And that's for one simple reason. The more

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<v Speaker 2>favorably disposed the investing public is to a given stocklet say,

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<v Speaker 2>the more its price has been driven up, and so

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<v Speaker 2>the lower its future expected returns. Now, the converse is

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<v Speaker 2>true of universally reviled assets. The time to own junk bonds,

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<v Speaker 2>for example, is when the term becomes an epithet that's

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<v Speaker 2>spat out of the speaker's mouth.

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<v Speaker 1>One of my favorite Twitter accounts is called TikTok Investors,

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<v Speaker 1>and this person pulls the most ridiculous investing strategies from

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<v Speaker 1>TikTok and shares them. And the one I saw this

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<v Speaker 1>morning was this woman who uses tarot cards to help

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<v Speaker 1>her select option trades, and you could tell by her

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<v Speaker 1>demeanor she really believes that this is useful and going

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<v Speaker 1>to be a long term win.

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<v Speaker 2>Yeah. One of my favorite quotes from Larry Thummers. It's

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<v Speaker 2>a short and pithy one, which is there are idiots

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<v Speaker 2>look around.

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<v Speaker 1>So our final two questions, how can we overcome psychological

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<v Speaker 1>biases to make better and more rational investment decisions?

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<v Speaker 2>Well, first of all, you trade as little as possible,

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<v Speaker 2>and secondly, you sort of psychologically internalize the Tobin separation theorem,

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<v Speaker 2>which basically separates out acid classes by how much risk

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<v Speaker 2>they have. And so in the Tobin separation theorem, there

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<v Speaker 2>are only two acid classes. There's the risky one, which

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<v Speaker 2>is stocks, which has high returns, and there's the safe one,

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<v Speaker 2>which has low returns. And so the key thing is

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<v Speaker 2>to cleanly separate those two things in your mind. And

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<v Speaker 2>you do that by making sure that your riskless apps,

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<v Speaker 2>riskless assets really are riskless. And you know, when the

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<v Speaker 2>experiment hits, the ventilating the system, corporates and even municipal

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<v Speaker 2>bonds are going to make you take a haircut on

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<v Speaker 2>those holdings if you want to use them to buy

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<v Speaker 2>cheap stocks or simply to pay for your groceries. Another

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<v Speaker 2>way of saying that is there's a reason why Warren

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<v Speaker 2>Buffett keeps twenty percent of Berkshire in t bills and

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<v Speaker 2>cash equivalents.

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<v Speaker 1>Sounds like you're describing the sixty forty portfolio.

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<v Speaker 2>There's nothing wrong with the sixty forty portfolio. You know,

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<v Speaker 2>once every couple of years you'll see a headline that

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<v Speaker 2>the sixty forty portfolio is dead. And you know, I

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<v Speaker 2>think that anybody who says that needs to wear a

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<v Speaker 2>sandwich board that says I don't know what I'm talking about.

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<v Speaker 1>Yeah, the last time that was said was right before

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<v Speaker 1>a pretty substantial move down inequities, although to be fair,

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<v Speaker 1>there was a modest move down in bonds as well.

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<v Speaker 1>Our final question, how best should we manage our own

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<v Speaker 1>investment behavior?

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<v Speaker 2>Well, there's, as we alluded to earlier, there's system one,

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<v Speaker 2>which is your you know, your emotional reptilian brain. And

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<v Speaker 2>there's system two, which is your inner mister spock, your

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<v Speaker 2>logical internal processes. And the trick is to train your

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<v Speaker 2>system to your logical system, to listen to your system

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<v Speaker 2>one and to learn when it's acting up. And I've

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<v Speaker 2>I've found, for example, that the most profitable purchases I've

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<v Speaker 2>made have been accomplished when I felt like I was

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<v Speaker 2>about to thrill up.

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<v Speaker 1>I know the feeling, so to wrap up. Overcoming our

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<v Speaker 1>own psychology and making rational decisions is the key to

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<v Speaker 1>long term success in the markets. Avoid trying to pick

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<v Speaker 1>glamour stocks, avoid market timing, and most important of all,

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<v Speaker 1>avoid giving in to your emotions when things get dangerous.

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<v Speaker 1>Stay with your financial plan, invest for the long term,

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<v Speaker 1>and you'll be fine. I'm Barry Redults and this is

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<v Speaker 1>Bloomberg's At the Money