The Behavioral Investor

What’s it about?
The Behavioral Investor (2018) explores the subconscious thought patterns and emotions that influence
financial investors. Author Daniel Crosby provides insight and guidance that will help you overcome your
natural inclinations so that you can make better financial decisions.
Who’s it for?
● Financial investors who want to achieve better results
● Aspiring traders developing financial strategies
● Anyone with an interest in psychology
About the author
Daniel Crosby is a psychologist and behavioral finance expert whose ideas have been published by
Huffington Post, Risk Management Magazine, and in a monthly column for Investment News. He is also
co-author of the New York Times best-seller, Personal Benchmark: Integrating Behavioral Finance and
Investment Management.
Introduction
What’s in it for me? Discover how your behavior is subconsciously impacting your investments.
What drives your financial decisions? Is it heated emotion or cool rationale?
If you've had investment success in the past, you might take this as proof that you're in control of your
money. But no matter how experienced you are as an investor, you're also a human being with a brain
that doesn't function well when faced with complexity or stress.
So, if you want to be a successful investor, you have to understand how your brain responds to its
environment and how it can influence you in ways you might not even realize until it's too late. Only
then can you make better financial decisions and leave your money mistakes firmly in the past.
In this summary, you'll learn
• the truth behind the Mona Lisa's fame;
• the irrational reason you favor particular stock tickers; and
• the connection between the weather and trading.
To be a successful investor, you must understand how your brain works.
What drives the stock market?
Many people think it's money. After all, money is at the heart of every portfolio. But far more important
than the money people invest are the people who invest that money in the first place. The people are
the ones who make the decisions to buy, hold, and sell.
Unfortunately, those decisions are often bad. Why? Because as wonderful as our brains are, they
weren't designed to work in complex, stressful situations. So, if you want to make good financial
choices, you need to realize that your brain won't always lead you in the right direction.
The human brain was designed to keep our prehistoric ancestors safe. And even though you probably
don't go to work facing mortal danger from saber-toothed tigers in the bush, your brain still acts as if
you are.
For example, whenever you're assessing financial risk, the brain areas responsible for avoiding attack
light up. Because your brain thinks you're being threatened, it limits its focus to these areas to keep you
alive. This makes it harder for you to think clearly and makes it more likely that you'll overlook important
information.
Our brains also encourage us to be impatient. They do this by giving us a hit of dopamine - a hormone
that makes us feel good - whenever we do something that results in immediate success. Because we like
that feeling, we'll do whatever it takes to get it. Sadly, that means you, as an investor, might sabotage
your financial plans because you're tempted by short-term wins instead of long-term gains.
Intellectually, you might know that it's not a good idea to chase every opportunity to make a quick buck.
But our brains are desperately money-hungry. According to Dr. Brian Knutson of Harvard University,
humans are drawn to money without any reference to its actual value. This makes it difficult to resist the
promise of reward.
In truth, your brain's money-lust will always cloud your judgment. But if you're aware of it, you'll be
better placed to overcome your brain's impulses and stop yourself before you do the wrong thing.
You're not as rational as you think.
If you study the stock market in relation to the weather, you'll notice something strange: all around the
world, people invest more in spring and summer. This behavior echoes that of our ancestors, who
stockpiled food in warm seasons so they wouldn't starve in winter.
Another interesting observation is that most markets have low returns on cloudy days. Scientists believe
that this is because we aren't as happy when it's gloomy outside. That sadness makes us feel more
vulnerable, so we're less likely to take a gamble.
These and other patterns show that our behavior is heavily influenced by our feelings. So, instead of
pretending that you're a rational adult, it's time to accept the truth that you're not.
When it comes to making decisions, we humans are experts at justifying our choices. This helps us
maintain the belief that we're capable of doing the right thing. We're also good at demonizing the
option we didn't take. This reassures us that we made the right choice.
If someone challenges our decisions, we become defensive, even if they present us with new
information that shows we made a mistake. Sadly, this ego-driven desire to preserve our self-identity
makes it difficult to change course if a decision doesn't pay off. It's the reason people cling to failing
investments instead of cutting their losses and moving on.
In fact, our human need for comfort makes us prefer the familiar to the unfamiliar, even if the familiar is
boring or bad. And because we have such a strong fear of loss, we hold on to what we already have,
even at the expense of potential gain. This leads to all kinds of strange situations.
For instance, when the German government had to demolish a town to mine some land, they offered to
rebuild it however the residents wanted. But the community chose to have the town rebuilt exactly as it
had been, even though the design was neither practical nor attractive.
To succeed as an investor, you need to get used to being uncomfortable. Because the markets are
constantly in flux, you'll always face potential losses and regrets. But if you accept this, you can move
forward with the best course of rational action instead of letting your emotions keep you stuck in the
past or paralyzed by fear.
Overconfidence is a liability.
Imagine where we'd be without confidence. There'd be no scientific discoveries, innovative businesses,
or countless other wonders of the modern world.
But while our human tendency to be optimistic about our circumstances can fuel a positive mind-set, it
can also go too far. That's when overconfidence leads to destructive, ego-driven behavior.
Typically, when investors experience wins, they believe their success is due to their unique skills and
might fail to see that the whole market is up as well. Their overconfidence could cause them to keep
buying, even if stock prices are already high. This goes against the "buy low, sell high" rule-of-thumb
that every investor should follow.
On average, investors overestimate their yearly returns by 11.5 percent, proving that they're not quite
as skilled as they believe themselves to be. And when returns decrease, investors become less able to
identify them at all. This is because their egos can't bear to face failure. That's why, if you want to be a
successful investor, you have to leave your ego behind at the start of every day.
Overconfidence is often the reason investors fail to diversify their portfolios. When a company's wealth
is growing, investors can be fooled into believing they've found a sure winner. But even if a company's
stock is strong, it's never a good idea to put all your eggs in one basket. Instead, your portfolios should
have around 20 stocks each. This is crucial since the market involves lots of uncertainty and a fair
amount of luck.
Diversification doesn't just reduce the odds of catastrophic loss by spreading risk. It's also useful when
you're trying to make market predictions. That's because pooled judgments that take many opinions
into consideration are far more successful at predicting outcomes than individual guesses. According to
economist R.M. Hogarth, seeking out a dozen estimates will give you sound guidance.
Just beware that humans are always at risk of confirmation bias - where we seek out opinions that echo
our own as proof that we're right. Because of this, it's important to obtain predictions of a stock's
performance from sources who use different forecasting methods. If you don't, your ego will be
satisfied, but you won't benefit from the crowd's wisdom, meaning you won't make informed decisions.
To invest successfully, you must embrace the unfamiliar.
Many people consider the Mona Lisa to be the pinnacle of artistic excellence. So, it may surprise you to
learn that the painting was relatively unknown until 1911 when it was stolen from the Louvre.
For two days, no one even noticed it was missing from the museum. But newspaper articles about the
theft created a media sensation. Two years later, when the painting was finally recovered, people
flocked to see it. So, it was the painting's scandalous story, not its artistic merit, that made it so popular.
This story reveals the human tendency to value what's familiar. Because it takes a lot of energy for your
brain to make difficult decisions, it looks for ways to cut corners by defaulting to what it already knows.
Sadly, when it comes to investing, this tendency puts your portfolio at risk.
If you still doubt that humans prefer the familiar, just think about the stock ticker names that grab your
attention. Many investors favor those that are easy to pronounce, like MOO, and consistently dismiss
ones that aren't, like NIT.
Similarly, the tendency to prefer the familiar is the reason people overinvest in domestic stocks.
Theoretically, the split of equities across your portfolio should correspond with the size of each country's
market. But in practice, this rarely happens.
For example, British investors tend to fill 80 percent of their portfolios with homegrown stocks, even
though the UK holds just 10 percent of the world's market value. This home bias means investors are
missing out on international opportunities. It also puts portfolios at risk in the event of a disaster.
Of course, no one likes to believe that catastrophe will hit them. Instead, normalcy bias makes us think
we've already experienced everything we're going to. That's why people often wait until the last minute
before evacuating in the face of a natural disaster.
To be a behavioral investor, you have to accept that there will always be upheaval in the financial world.
To counter this uncertainty, you should build diverse portfolios to carry you through the natural highs
and lows.
To invest successfully, you must broaden your views.
In the 1690s, colonial Massachusetts was gripped by a fear of witches. Women accused of witchcraft
were tried according to a ludicrous procedure. If a woman floated when thrown in deep water, she was
convicted of witchcraft and sentenced to death. If she drowned, she was deemed innocent. So,
regardless of the verdict, the accused would always die.
Why did the panicking residents fail to see the absurdity of the witch trials? Well, as humans, our
attention is always drawn to situations that are high risk but low probability - in other words, those that
whip our emotions into a frenzy. This attentional bias makes us fixate on limited information, ignoring
other relevant data.
But investing always carries an element of risk, so you need to think expansively and don't overlook the
obvious.
In a high-risk situation, it's easy to become blind to simple solutions. That's why many investors looking
for an edge in the financial market end up with overly complicated strategies.
And yet data analysis company Morningstar discovered that it isn't a brilliant manager or a state-of-the-
art process that predicts a fund's performance. It's investment fees. But if you're consumed by a desire
to succeed -and a fear of failure -you're at risk of overlooking this simple evaluation tool.
Another mistake is when investors focus on a stock's performance over a limited timeframe. This is
especially common if your investment decisions are guided by probability, which works best over
extended periods of time.
So, if you look at the market on any given day, it'll seem random. If you take a step back and look at
monthly trends, you still won't find much evidence that you've invested wisely. But if you zoom out and
look at annual performance, you'll see the big picture. Unfortunately, many investors panic before
they've given stocks enough time to reveal their true value.
To be a behavioral investor, you need to take the long view. The first step is to examine your portfolio
for any stocks at risk of bankruptcy or fraud and get rid of them. Next, diversify to avoid catastrophe.
Finally, place your trust in time. This will help you through any short-term failures.
To invest successfully, you must manage your emotions.
How many emotions do you think a human being can experience?
Seventeenth-century French natural scientist Rene Descartes believed we had just six core emotions.
But modern scientists take a different view. Dr. Watt Smith, author of The Book of Human Emotions: An
Encyclopedia of Feeling from Anger to Wanderlust, has identified over 150 different emotions. What's
more, these emotions can combine to create complex secondary feelings like nostalgia, which blends
longing and sadness with joy.
Every day, while you're making financial decisions, the array of emotions you're experiencing is at play.
It's important not to underestimate how powerful they are and how much they can influence the
choices you make. Because, when it comes to investing, emotions are a serious liability.
How you perceive any situation is influenced by your shifting emotional landscape. Similarly, what you
do with your money depends on how it makes you feel.
Just look at the work of Nobel Prize-winning economist Richard Thaler, who discovered that how we
label buckets of money affects our decisions. For instance, we'll save money labeled "rebates" but spend
any "bonuses."
Goals-based investing - also known as personal benchmarking - is based on this tendency. To use it,
divide your money into three buckets - safety, income, and growth - then invest accordingly, using your
emotions to guide you.
While you can use emotions as part of your strategy, feelings aren't always helpful when it comes to
investing. That's because strong emotions lead us to make bad decisions. You can counter this by
slowing down your thinking, which is a skill you can learn through meditation.
Mindfulness exercises heighten your awareness by creating space to consider the details of a situation.
This prevents you from falling back on those familiar options and leads you to stronger and more
considered decisions over time.
Meditation is now seen as such a valuable tool for investors that companies like BlackRock and Goldman
Sachs have programs for their staff. Since it lowers activity in areas of the brain that control greed,
investors who meditate regularly are less likely to make mistakes by chasing fast rewards.
So, even though you may think of yourself as a well-regulated individual, remember that emotions are
so universal that most of the time, you don't even notice them. But if you can pay attention to your
emotions, you'll know when to be guided by them and when to regulate them instead.
To be a successful investor, you must understand how influential your intuition is.
Your brain is a data-processing powerhouse. In fact, it can process over eleven million bits of data at any
given time. And yet only around 50 of these bits become conscious thoughts. That means the vast
majority of your brain's processing power is dedicated to your subconscious mind.
When you consider how little processing power our brain dedicates to conscious decisions, it's not
surprising that many investors believe in trusting their gut instincts. But this is not a reliable investment
strategy.
Conscious thought is extremely skilled at making simple decisions. But it's not that useful when you
need to make a complicated choice.
The more you consider your options, the harder it is to make a decision. That's because it's difficult to
figure out which aspects are more important. And while you're struggling to weigh up the pros and cons,
you become less confident about your ability to make a solid choice.
Humans can only make sound decisions when outcomes are predictable, the situation is static, and
there's plenty of quality feedback available to guide us. Sadly, you'll never find these characteristics in
capital markets. So, if you're an investor, you need to accept that conscious thinking isn't the best
decision-making tool.
Luckily, you can turn to model-based approaches - like using extrapolation algorithms - to compensate
for your brain's shortcomings. In fact, when it comes to decision-making, models perform just as well as
humans - and sometimes even better - a startling 94 percent of the time. This makes them invaluable
during moments of intense stress and at other times when human judgment is clouded by fear.
As an investor, you'll be exposed to constant financial news, endless opinions, as well as the greed of
others and yourself. Without a solid model in place to help you make good decisions, you'll inevitably
crack under the stress. But if you've committed to following a model, your investment decisions won't
be at the mercy of how you feel.
To be a successful investor, you must manage your fear of market bubbles.
During the dot.com boom, investors went internet-mad, buying up shares in companies with tech-
sounding names. This led to some hilarious scenarios, like the share price for Mannatech Inc.
skyrocketing by 368 percent in the first two days of its public offering. No one realized that Manna tech
had nothing to do with the internet. It manufactured laxatives.
Bubbles like the dot.com boom are a bit like falling in love. We become infatuated with an idea - such as
the notion that every tech company will make us rich. We also get so caught up in our romance that we
ignore all the warning signs. Eventually, reality sets in, the bubble bursts, and we have to pick up the
pieces.
Although few investors want to acknowledge it, bubbles are a natural part of capital markets. And yet
bubbles also aren't as common as you might think.
Between 1800 and 1940, there were just 23 bubbles in the UK and US markets. But because the
experience of them is so traumatizing, they tend to dominate public memory. That's why American
investors trading in the 1980s will fixate on the crash of 1987, forgetting that US stocks rose 400 percent
over that decade.
Unfortunately, knowing the truth about bubbles doesn't remove the widespread fear of them. In fact,
fear of bubbles is powerful enough to paralyze investors, which is why it's so important that you learn
how to manage your emotions. Otherwise, you'll end up stuck when you'd be better off embracing
opportunity instead.
To navigate through the inevitable rise and fall of the market, create a rules-based system that will guide
you to becoming more conservative when things are unstable. That way, you can focus on being patient
and acting infrequently, rather than behaving reactively based on how you feel on any given day.
A common system to achieve this is a momentum-based model with a 200-day moving average.
Following this model means holding assets when their price is above their 200-day average and selling
them when it drops below that number. A similar model is based on a ten-month moving average.
Lengthy periods of inactivity seem at odds with the frenetic pace of the stock market. But they give you
enough time to shift the odds in your favor. By committing to your system even in the face of fear, you'll
better manage your emotions and overcome the instincts that drive you toward poor decisions.
Final summary
The key message in this summary:
There's a huge amount of volatility in capital markets, but this is predominantly driven by investor
decisions, not money itself. Unfortunately, our brains aren't as good at making decisions as we think.
Anything from the weather to how familiar a ticker name sounds can influence our investment choices
without us even noticing. That's why it's important to develop a deep understanding of how your brain
reacts to a stressful work environment and how you can consciously choose to make better investment
decisions.
Actionable advice:
Manage stress using the R.A.I.N. model
In moments of acute stress, turn to Michele McDonald's R.A.I.N model to return to a calm state of mind.
Start by Recognizing what is physically happening to you, like an increase in your heart rate. Next,
Accept what you've observed, even if you don't like it. Then Investigate any narratives you're telling
yourself about the situation and identify other thoughts you're having. Once you've done that, you're
ready for the final step - Non-identification - where you acknowledge that feeling stress doesn't mean
you have to be defined by it.