Book Review & Summary: The Behavioral Investor by Daniel Crosby
This was an excellent book about behavioral investing that should help you improve your investing process.
Too many investors neglect their process and get overly excited by a stock pick they read about on their favorite financial website, or, probably worse, that they hear about from a friend or someone they respect. They don’t do their own full diligence and wind up getting lucky or burned. (“You can be right and still be a moron” for making a poorly thought-through decision, according to Crosby.)
Dr. Daniel Crosby, a psychologist
Review: Great Content, Mediocre Structure
The content is important, which is why I’m writing this synopsis. He pulls insights for investing and investors from dozens, if not hundreds, of studies and meta-analyses from people like Kahneman and Tversky, among many others. I’ll cover those insights below.
My main issue with the book is its structure. A well-structured book would either build an argument successively, piece by piece in each chapter, or it would map out its content so that each main and supporting idea would be discussed independently, yet taken together, the ideas would collectively cover the whole space. (Consultants call this being Mutually Exclusive and Collectively Exhaustive, or “MECE,” — pronounced “mee-see.”)
This book should have used the latter strategy, but instead suffered from some serious repetitiveness. Chapters 4-7 cover the main psychological biases investors face. Crosby then repeats a lot of those concepts — while introducing new aspects of them, as well — in the subsequent four chapters that are supposed to discuss how to overcome those biases.
When you keep shifting between the problem statement(s) with their resolutions, your ideas get confused and the takeaways become less apparent.
The final 5 chapters are a mess, structurally. There is repetitive content from the first 8 chapters that goes beyond making connections for the reader. It is a heap of thoughts about risk, active vs. passive investing, bubbles, value and momentum factors, building a rules-based process, etc. Again, it’s good content, just put together in a suboptimal way.
I do like how most chapters include synthesized bullet points at the end. There were a few chapters where I thought those synopses didn’t quite adequately cover the meat of the chapter, though, so you can’t rely just on reading those. It should also come as no surprise that the final 5 chapters, where Crosby loses the plot the most, have no end-of-chapter summary.
Anyway, rather than write a typical summary of the book, I’m going to re-structure the key points of the book into a more cogent storyline, but I’ll mostly use quotes from the book in doing so.
The basic premise of the book is: markets are made up of people, so to understand and profit from markets, we must understand human nature.
Sociologically, we’re wired to not be good at investing:
“Trusting in common myths is what makes you human. But learning not to is what will make you a successful investor.”
Neurologically, it’s the same. Our brains are outdated, impatient, and hungry:
“Your brain is constantly searching for ways to go into energy saver mode and not work quite so hard.”
“Important information is almost of necessity hard to digest. Our mental fatigue ensures that we leave relevant new information to the side and rely instead on well-trodden paths of dubious quality.”
“Our ability to control our short-term impulses toward greed is limited and that we are more or less wired for immediacy.”
“Money … is so important that we eschew reason, ignoring what is economically best in favor of what is emotionally satisfying.”
“Market conditions are constantly in flux and can lead us to learn the wrong lessons.”
“The anticipation of reward releases a flood of dopamine, which primes us to become sloppy and undisciplined; success begets failure.”
Physiologically, we are set up for failure:
“Physical states can impact emotion just as surely as the reverse is true.”
“Loss aversion kept our ancestors alive. It keeps you from becoming a successful investor.”
There are 4 Types of Behavioral Risk: Ego, Conservatism, Attention, and Emotion. Each Requires Different Strategies to Overcome Them.
“We look for supporting evidence, we congratulate ourselves for believing as we do, and we react violently against attacks to our worldview.”
“Our need to view ourselves as competent and maintain ego lives somewhere so deep within us that not even cognitive impairment can touch it.”
“Paradoxically, the more ambiguous a situation, the more certain we become.”
Crosby identifies three types of overconfidence to watch out for: overprecision (excessive certainty),
“When self-esteem is threatened, … people lose their ability to self-regulate. Arrogant people in particular … rush to prove their critics wrong, even if it means taking big risks.”
“It is egoistic in the extreme to assume that you can predict the future, but nihilistic in the extreme to assume that nothing can be known.”
Be rules-based instead of using discretionary processes:
“The behavioral investor realizes that course-correcting bad ideas is nearly impossible and that designing a system inoculated against untruth is the far better one.”
“Bubbles are a natural, recurring feature of capital markets… Have a rules-based system for avoiding catastrophic loss that is infrequently (i.e., every few years) activated.”
Diversify (but still have conviction):
“Diversification is a concrete nod to the luck and uncertainty inherent in money management and an admission that the future is unknowable.”
“Put in place a plan that diversifies across geographies and asset classes, both familiar and foreign.”
Be honest with yourself about what you don’t know, and force yourself to explain your beliefs/assertions using facts & data:
“‘I don’t know’ is a profitable if seldom uttered sentiment.”
“The next time you feel as though you must buy or sell a security, or that you are certain of where the financial markets are headed, take a moment to explain, in detail, the factual reasons why this is so.”
Ask “How do I know I’m right?” or “How might I be wrong?”
Gain greater knowledge using Richard Feynman’s 3 part process:
- Figure out what you don’t know
- Educate yourself
- Teach it to a child or novice
Check your level of certainty:
“Everyone thinks that they are a contrarian… True contrarianism is painful and should cause considerable self-doubt. If your brand of swimming upstream doesn’t hurt, it’s unlikely to work.”
Or, to paraphrase Crosby: if you feel overly passionate about one of your investing ideas, you probably haven’t thought about it enough.
“All paths to conservatism, it would seem, run through some form of loss aversion.”
“Individuals feel stronger regret for bad outcomes that are the consequence of new actions taken than for similar bad consequences resulting from inaction… Put simply, if you’re going to make a mistake, your brain would rather you make a mistake by doing nothing.”
“The sunk cost fallacy, as it is known, means that the larger the past resource invested in a decision, the greater the inclination to continue the commitment in subsequent decisions.”
“The implications for investing are clear: we tend to overvalue what we own and undervalue unowned alternatives.”
“Our conservative nature already means that we see less risk in the familiar and so are likely already overweight what we know.”
Have a long-term orientation:
“By privileging today over tomorrow and certain mediocrity over possible greatness, fearful investors provide behavioral investors with an equity risk premium that is improbably large. This premium can be earned by doing the opposite: by privileging tomorrow over today.”
“Behavioral investing must be long-term to be effective.”
Procrastinate (a little):
“So, when tasked with making an important
investingdecision, take time to reconsider your immediate choice and see if you still think the same after more thought.”
Use heuristics/rules of thumb:
“Risky situations, where probabilities are understood, lend themselves to logical and statistical thinking. Uncertain situations like capital markets, where ‘unknown unknowns’ run rampant, require looser controls in the form of rules of thumb.” (Heuristics)
“The availability heuristic, which simply means that we predict the likelihood of an event based on how easily we can call it to mind rather than how probable it is.”
“Storytelling bypasses many of the critical filters we apply to other forms of information gathering… For this reason, stories are the enemy of the behavioral investor.”
“Salience is the psychological term for prominence, meaning that our attention can be hijacked by low-probability-high-scariness things like shark attacks while ignoring high-probability-low-scariness dangers like taking a selfie near a busy street.”
Avoid telling yourself stories, or listening to others’:
“To manage risk in any meaningful sense means stepping outside of the stories we tell ourselves and considering information in an emotionless a manner as possible.”
Evaluate investment media: evaluate the source, question the drama, examine the tone, consider the motive, check the facts.
“Complicated macro narratives should be scrupulously ignored.”
Focus your attention on what matters:
“A part of any sensible approach to security selection is determining what matters most and a focus on those variables to the exclusion of the cacophony all around. If everything matter, nothing does.“
“Behavioral investors, as the sworn enemy of noise traders, must do just the opposite: 1. Revel in principled contrarianism and 2. Cultivate an understanding of the empirical and psychological markers of signal.”
“Low levels of emotion give rise to a high dispersion of ideas and behaviors, but strong emotion has a decided homogenizing effect that can harm the investor with even the best intentions. Emotion makes you a stranger to your rules.“
“They were simply unable to predict the degree to which passion would change them.”
“All too often we confuse the intensity of our longing with the probability of our winning… We tend to conflate our desire for an outcome with its likelihood.”
“Even the most educated professional investor suffers from what is commonly known as restraint bias, or the tendency to overestimate our ability to control impulsive behavior in the moment.”
“Any strong emotion has the impact of shortening time horizons and increasing impatience, two of the worst things an evidence-based investor could ever hope to do.”
“Emotional distress (the kind caused by market volatility) leads to a failure to consider all options and shifts people in favor of high-risk, high-reward payoffs, even if they are objectively poor choices.”
“Good investing, tedious as it can be, is inappropriately labeled as risky when it is really just boring.”
“It can be tempting to want to stop emotion in its tracks, but oftentimes, the most adaptive approach is to repurpose it for more favorable outcomes.”
“Emotion in and around financial markets is often lumped into one of two categories: fear or greed. Meditation, it would seem, is well positioned to tame both…. Both show evidence of being tamed by the simple act of mindfulness meditation.”
“At their core, mindfulness and meditation are all about focusing on present thoughts and actions in a non-judgmental way.”
“Ideally, investment managers would work somewhere between 4 and 12 days per year and spend the other 361 days a year in the pursuit of ideas that challenge their existing beliefs.”
HALT – hungry, angry, lonely, tired – “abstain from making important decisions in any of these emotional states.”
“Avoid emotion-inducing situations like watching financial news and frequently checking account balances.”
“Build a model and follow it slavishly.”
Building behaviorally sound portfolios
Systems Trump Discretion
Discretion and intuition don’t work:
“The following [are] the criteria for making good discretionary decisions: predictable outcomes, static stimuli and the availability of good feedback. Capital markets, in which human behavior is absolutely central, meet none of these conditions.”
“In the absence of a certain level of predictability and rapid feedback, neither of which are present in financial markets, intuition lacks soil fertile enough to take root.”
Therefore, you need to use a rules-based system that you evaluate not on the outcomes but on the quality of the process:
“Learning to score you investment wins and losses based on the quality of your decisions and not on the quality of the outcome is the key to managing your emotions, appropriately measuring your own performance and living to fight another day.”
“A behavioral investor begins by doing no harm and screening out any stocks that appear to be fraudulent, at risk for bankruptcy, or otherwise sick.”
Diversification and Conviction Can Coexist
We use diversification to overcome ego, but this doesn’t mean you should own 100 stocks. Most gurus from Buffett and Graham to Klarman recommend 6-30 holdings that you know well and believe in.
“We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.”Buffett 1993 shareholder letter
“Even inexpensive, high quality stocks with a catalyst have an uncertain fate. By bundling risk (i.e., diversifying), the likelihood increases that doing the right thing for the right reasons will pay off.”
On thinking about catalysts as part of gaining conviction:
“Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.”Buffett
“A low likelihood event with great upside or downside may be well worth attending to.”
Prepare for Bursting Bubbles Without Being Too Fine-Tuned to Them
“The default state of a strategy should be bullishness [markets usually go up], but ought to include a contingency for low-likelihood-high-intensity events.”
“But there are two things that begin to give investors pause and would warrant taking a more defensive position. The first is flagging momentum, which increases the probability that the market will fall in value. The second is steep valuations, which increase the intensity of the potential crash.”
“Thus, the behavioral investor has the default position of being aggressively invested until such time as momentum begins to slacken (probability) and valuations are extreme (intensity).”
“The behavioral investor knows market timing is typically ineffectual, but is also aware of times in history when broad market levels have become obviously and grossly disconnected from any measure of fundamental value.”
Less is More When it Comes to Information
This is largely covered in the “Honing Attention” section. Don’t succumb to storytime, focus on what matters, don’t watch “Mad Money.”
I won’t repeat myself even though the book does!
Validate Investing Strategies by Looking for Evidence, Theory and Roots in Behavior
“Arbitraging emotionality seems to be an enduring form of investing advantage – one that may actually be increasing.”
3 Tests of an Investable Idea:
1. It’s supported by the data
“The first hurdle an idea must clear to be considered worthy of a behavioral investor is that it has a rich history of empirical support. The data must support your assertion, period.”
2. There’s a strong causal theory behind it
“If there is no good reason for a data point to correlate with outsized returns, it probably doesn’t.”
3. It’s behaviorally difficult to stick with
“Smart people discover truths about the market, share them with the world, and return-hungry arbitrageurs ensure that those truths don’t stay true for long.”
“But what calendar effects, and many other market anomalies, lack is the third and final trait that behavioral investors require: it must owe to an enduring psychological tendency. There is no psychic pain in arbitraging calendar effects… For a factor to be worthwhile to a behavioral investor it must be empirically supported, theoretically sound, and behaviorally intransigent.“
Active vs. Passive. vs. Rules-Based Behvioral Investing
Rules-based behavioral investing is: low fee, diversified, has the potential to outperform, has low turnover, and manages bias. Passive investing cannot outperform and does not manage behavioral biases. Active investing is not
There are many reasons to be a passive investor:
“Passive investing should be the de facto choice of those uninterested in the art and science of investment management.”
“Know-nothing investors … are likely to beat more than 90% of active managers and have time to focus on pursuits more meaningful than compounding wealth.“
The rise of passive investing yields more opportunities for other investors, however.
“The very inclusion of a company in an index leads to an immediate increase in the price-to-earnings and price-to-book ratios of the stock.”
“Increasingly, large swaths of a corporation are being bought and sold out of habit and not conviction, meaning that prices are less and less reflective of true value.”
“The behavioral investor understands and seeks to mimic the best parts of passive investing — low turnover, rock bottom fees, and appropriate diversification — without succumbing to absentminded buying and selling.”
Value and Momentum: The Behavioral Investment Factors
“Value stocks tend to provide greater returns with lower volatility and incredible consistency.”
“Value investing is sensible, empirically robust and has behavioral roots that make it psychologically and physically hard to execute, passing all 3 hurdles of a sound behavioral investment idea.”
You need sound theory.
“All else being equal, we look to price as the foremost determinant of quality.”
“The relationship between cost and value is more tenuous than ever and in capital markets it can be accurately said to be inverse. The more you pay, the less you get.”
What You See Is All There Is (WYSIATI), coined by Daniel Kahneman, tells us that humans basically take at face value a stock’s price, return distribution, and fundamentals, and project that forward as-is.
“For many investors, their mental representation of a stock is given by the the distribution of the stock’s past returns… People adopt this representation because they believe the past return distribution to be a good and easily accessible proxy for the object they are truly interested in, namely the distribution of the stock’s future returns.”-Barberis, Mukherjee & Wang, “Prospect Theory and Stock Returns: An Empirical Test” as quoted in “The Behavioral Investor”
Value investing is physically painful. Being the odd contrarian leads to feelings of social exclusion that generate brain activity in the same parts as real, physical pain.
“It is innate tendency of humankind to project the present state of things into the future indefinitely. In so doing, we create one of the most important exploitable market anomalies – momentum.”
Theoretical/behavioral source: overconfidence and self-attribution.
“This overconfidence becomes paired with self-attribution in the sense that investors attribute the rising prices to their own stock picking genius and not some combination of luck and skill, which is more likely the truth.”
Or is it confirmation bias and representativeness?
“People make a purchase believing what they believe, do not want to be disabused of those notions, and look at recent price moves as being indicative of future moves.”
“The premier market anomaly is momentum. Stocks with low returns over the past year tend to have low returns for the next few months, and stocks with high past returns tend to have high future returns.”
Value and Momentum Factor Premia Are Durable
Crosby shares a chart originally produced by Ben Carlson that shows the annualized premia for value, size, beta, and momentum factors from 1927-2014:
The Value and Momentum factors do seem to pass Crosby’s test for a go-forward investing strategy. I would’ve loved for him to investigate the Beta factor, as well.
Final random tidbits
“Behavioral investors take a middle path, understanding that the question is not ‘Is the price right?’ but ‘Where is the price headed?'”
“Invest in a basket of stocks that imperfect subjective appraisal has unfairly punished, but that a positive feedback loop will soon reward with a push toward fair value.”
“Whatever success you achieve as a result of having read this book will come, not as a result of personal genius, but through acceptance of personal mediocrity.”
I hope you enjoyed my synopsis of The Behavioral Investor and are now ready to incorporate what you’ve learned into your own investing process.