Are You Your Own Worst Enemy?

You ask an audience, "Hey, you know, the market does 10% over a long period of time, is that a good return in any given year?" And I think the answer that most people will give is not yes, it's, "Well, it depends." What were the other options? "It depends because what were the other options? I don't want 10% if 10% was the worst option." Exactly. So, yeah, we're stuck in this narrative. There's no way out, there's no way out. There is a way to navigate it successfully. Yeah. But there's no way to stop this from happening in our brains, it's just... It's a great point, Jake. You think about we've had solid returns the last three years, really good returns in the US, and people go, "Yeah, but I just wanted Nvidia." Yeah, but. You know? Yeah, but. But if I had put it all in Bitcoin, I could be retired right now, or, you know, I haven't looked up Bitcoin in a couple days, so, you know. Welcome to "The Informed Investor," where we break down the latest financial headlines, bringing in research and insights to help you separate the news from the noise. Welcome to "The Informed Investor," a show brought to you by Dimensional Fund Advisors, a global asset manager bringing financial science to investing. Today's topic is investor behavior. What are some of the behaviors that come into play in the decisions we make when it comes to our money? I'm Mark Gochnour. I'll be joined today by Jake DeKinder and our special guest, Scott Bosworth. Thanks, Mark. Thanks for having me. Scott, welcome to the show. So Scott, you've been in Dimensional around 30 years or so. Almost, yeah. Right? You started out in the portfolio management group. I did. You led a group in the sales team, and now you oversee a group of speakers. I do. That go out and speak at Dimensional events, industry conferences, really, all around the world. So it's great to have you here today. Scott, this is something that's been quite a hobby for you for a number of years. How did you get into this being a very personalized hobby for you? In 2009, I set out to create a presentation that maybe like relied less on the traditional Dimensional, "This is the evidence, this is the T stats, these are your statistics, these are your probabilities, now go have a successful investment experience." And to talk a little bit more about investor behavior and how it feels, and connect more with the emotional side of things. And that presentation and that work has evolved over the past 15 years, and I'm still doing it today. Let me read a couple headlines, and then we'll dive into and get into some of the findings that you had there. And, of course, Jake, I'll want you to weigh in on this as well. All right, a few headlines here. "The Cost of Chasing Trends: What Data Teaches Us About Investor Behavior," and then this one I really like, "Why Investors Sell Too Soon, Hold Too Long, and Regret It Later." So Jake, come to you and then we'll go back to Scott. But, you know, a lot of times we talk about, on the show, we've talked about the emotions, you know, fear and greed. But then there's some specific behaviors that actually do come into play and impact decisions we make. Yeah, and one of those headlines you read I thought was really interesting around this sort of like, what does the data tell us about investor behavior? You know, and I think about it a little bit, like, people know like, eat your vegetables, exercise, and yet they still don't do it. People know that smoking's bad for you, and they still smoke cigarettes. People don't do it in every aspect of their life. So why would you possibly think when it comes to money, somehow they're gonna make these like perfectly rational decisions? Right, right. Walk us through, I guess some of the key behaviors you've come across in- Yeah. Evaluating the research out there in this space. Well, and so Wikipedia has a page now. I mean, they've had a page for years that lists all the cognitive biases. And when I checked it a few weeks ago, there were 245 on that list. So it's a fairly robust- That's why I don't get into this space. It's way too complex. Well- It just means that we're all really messed up in the head is what it means. Well, what it actually means, I think, is there's been so much research on this now, and the academics are all over it. So they're coming up with new and clever names for different, unique sort of findings that they've uncovered in the research. But, you know, to me it kind of comes down to, you know, basic principles. The survival instinct, that underpins quite a few of what we call these biases. And they're, again, they're not unhealthy to have, you would want them, but survival instinct, and, you know, I like to say, "Look, nobody likes to be wrong," right? We don't like to make bad decisions that turn out, you know, that turn out wrong. We don't like to be in situations we can't control, and we don't like to get hurt. So we have all these psychological defenses that we've developed over however long to make ourselves feel better when that happens. Now, the survival instinct ones are not the ones that you would wanna correct, but you wanna have some way of acknowledging them when it's unuseful to apply them. But there are others, these what we call attention biases. The illusion of control. People will think they can time the market and that can kind of control how the markets behave. But those are, those attention biases are a lot easier for us to have kind of the ability to say, "Okay, I can have some life hacks or something to apply to my investment," sort of, you know, call it the recipe, "and I can check in with those every time I'm thinking about making a decision." Well, Scott, let's highlight a couple of these biases and then maybe give us a definition, an example of how it applies to investing. I think one of them is hindsight bias, but I'll let you kind of take it from there. Of my favorites of the 245 that are, you know, currently listed in Wikipedia, I would say there are certain ones that are far more relevant to us as investors, and you know, one of the ones I kind of start with is this idea of hindsight bias, right? There is an old saying about hindsight. What is it? "Hindsight is..." "20/20." "Hindsight's 2020," right? So hindsight, what does that mean? That means, well, when we're looking at the past, we know exactly what happened. We know exactly what transpired during, keep it to investing, transpired during any good market, bad market, what have you. So we feel like there's this certainty around, oh, okay, you know, I know exactly what happened. Now I'm gonna attach this narrative to why we got the outcome we got. And now it's gonna make me feel, even though this sounds like a weird trick, but it's gonna make me feel like the future is now gonna be easier to predict. So I'm gonna start looking for those same signals that maybe fit the narrative of what we live through. And I'm gonna start applying them to the future. And that really derails successful investing. This idea of hindsight bias, it is, to me, the most insidious of the biases when it comes to having a successful investment experience. If that continues to pollute the decision-making process for most investors, that's, more often than not, gonna lead to very suboptimal outcomes for people. Related to that is this illusion of control, right? So, that bias, as you can probably, you know, you can probably make this switch pretty easily, with that illusion that I can predict what's gonna happen, that gives me this illusion that I can somehow control markets, right? Right now, we've had a really good run of equity returns, particularly in the US, for the last couple of years. And, you know, yes, there's a lot of headlines that you all cover about the anxieties around being at all time highs, and we've covered that. But to me, it's almost like people are upset that the market has done well. Why? Why are they upset that the market's done well? Because they didn't put all their money in the parts of the market that did exceptionally well. It's almost like, you know, if you've ever played roulette, it's like putting your money on red and winning because red came up, but then being mad that you didn't put all your money on 12 red because you would've made a lot more money had you done that. And people can't, now that's, gambling is not a really good analogy for us in most cases, so take that for what it's worth. It doesn't completely, the metaphor doesn't completely work. You know, when you think about investing, you wanna be diversified. We're not making bets with our money, but these biases are very similar to what you see in gambling or sports betting or sports in competition and life, you know, marriage, you know, that sort of thing. So those two, linked, are I think very powerful and very important for people to understand and be aware of, as they're making investment decisions for the future 'cause we can't make investment decisions for the past, doesn't work that way. So would an example be, you mentioned, US has done really well recently from return perspective, and maybe, a year ago an I investor says, "Oh, emerging markets is due, it's ready to have a good run." And it turns out, last year, it did have a very good run. Is that a hindsight bias to say, "I knew it, and then now I have confidence to say I can predict what's gonna happen going forward?" Yeah, I mean there's pattern-seeking going on. I mean, that's another thing that gets covered quite a bit. So if it's, you know, we're looking at, the hindsight bias is also related to pattern-seeking, in that we're looking for some sort of narrative or some sort of signal that's gonna tell us about what's gonna do well in the next short term period of time. That might be a few months for some people, it might be a few days for some people, it might be a, you know, a short period of years for some people, but that pattern-seeking, it's like, you know, Mark, if I had a coin and I flipped a coin in front of you six times, let's say, or 10 times, and like, you saw me, okay, I flipped it 10 times and you saw eight heads, even though you are a smart person, and you know that a coin does not have a brain, doesn't have a memory, there's part of you that's gonna think, "Well, tails is due." It's due, it has to be due, right? It has to be due, right? And you're probably not gonna bet any money that tails is gonna come up more frequently than heads 'cause you're smarter than that, but we all get tricked into that pattern-seeking behavior with a random event. We think there's gonna be this reversion to the mean, but that's not what happens with a coin 'cause a coin doesn't have a memory. It is a very simple but incredibly complex thing for people to grasp that, you know, look, there's no memory there. So, and people say, "Okay, that's a fun experiment that psychologists can do," but I say, "Go back to roulette," they show you what the past spins are on the roulette wheel. There's a reason they have it up there. Yeah, they have it up there because they did an experiment years ago, the casinos did, and more people gambled, and they gambled more money if you showed them what the past spins were, so we're just wired that way. There's no getting around it. There's only awareness, and it requires a constant reminder of that awareness to make sure you're not falling prey to these biases, where it's going to hurt you as opposed to help you. What would the bias be, where we're all anchored to something. Everybody individually is anchored to something like, I sort of tend to think this is gonna happen. So when we read headlines, we sort of go to the ones that align with how we think and sort of ignore the ones that don't align with how we think. Yeah. Is that a bias, or is that just... Oh, it's a confirmation bias. So we, again, this is one of those, this is not an encapsulated bias, this is more of, I think of it as more of an attention bias. So this is just a bias where we like to feel good. We wanna surround ourselves with people that think like we do. So we consume information, and we join friendship groups where people have sort of the same beliefs that we do. And that just makes us feel better. It tends to polarize us as well, which is the downside of that. And that's a social thing. I'm not talking about social or politics, we're talking about investments on this episode. So as it comes to investments that, you know, seeking out information that may not support your prior beliefs is a really healthy thing to do. Doesn't mean you're gonna change your behavior based on that, but it will ground you in terms of the narratives you're consuming and sort of the anxiety you might have about whether we're in a all-time high or whether there's a recession coming or whether this stock is gonna do well or do poorly. One thing I wanna pick up on what Scott said, which I thought was really good, I loved your example there of when you said, "Well, I bet on red, and red came up, but I didn't bet on red 12, 12 red," right? And I think that's really applicable to what a lot of financial advisors have to deal with, where you achieved a good rate of return for the year, you're on track for your goals. In fact, this rate of return is what we baked into the financial plan. And yet investors are like, "Yeah, but my neighbor got X return," or, "Yeah, but this asset class did better." And it's really tough, sort of just saying like, "You captured red, and red keeps you on track for your goals. You don't even have to worry about the 12 part of it," but people go there all the time. Oh, yeah. Well, I do presentations all the time, and I think you do too, Mark, where it's like, you ask an audience, "Hey, you know, the market does 10% over a long period of time, is that a good return in any given year?" And I think the answer that most people will give is not yes, it's, "Well, it depends." What were the other options? "It depends 'cause what were the other options? I don't want 10% if 10% was the worst option." Exactly. So yeah, we're stuck in this narrative. There's no way out, there's no way out. There is a way to navigate it successfully. Yeah. But there's no way to stop this from happening in our brains, it's just... It's a great point, Jake. You think about, we've had solid returns the last three years, really good returns in the US, and people go, "Yeah, but I just wanted Nvidia." Yeah, but. You know? Yeah, but. But if I had put it all in Bitcoin, I could be retired right now, or, you know, I haven't looked up Bitcoin in a couple days, so, you know? I could be wrong. Yeah, the other one, Jake, you highlight too is, you know, there's a tool for the job, and we think about, let's just say, in this case, it's stocks. And you think, "Well, the goal of stocks is to grow our wealth over whatever our horizon is," 30, 40 years, yet we get so emotional around a one-year performance. Let's go back to '08, for example, where, you know, maybe it's down 40%. It's really painful. Yeah, but I'm worried about 30 years from now, so do I really even care that much? I mean, emotionally, it's easy to say it, but emotionally hard to sort of let go of that. When you're in the moment, right? That's the tough part, right? It's the same thing we said earlier, where it's like, yeah, you say you can stick it out when you're down 30%, until you're down 30%, see what happens. You don't know. Well, and we talk about long term a lot. And you can look at a period, with hindsight again, where your end year is really bad. But if you go back and say, "Well, what was your 30-year return with that really bad end year," it's a pretty good return. If you had said in 30 years prior, to say 2008 or something, "Hey, you're gonna get 9 or 10% in your stock portfolio over the next 30 years." Most people are like, "Great, okay, so I'm gonna reach my goals." The problem is, at the very end, you lost 40 or something like that. You had a really bad outcome at the very end, and you weren't planning for that, right? I mean, emotionally, that is incredibly hard to withstand, which is why people do risk-tolerance questionnaires. It's why they don't put all their money in the stock market. They have balanced portfolios. They have multiple asset classes, and it changes through time. You know, risk tolerance, it's like, Jake, you were saying this earlier, you know, can you withstand a 30% downdraw or drawdown? And someone goes, "Yes, I can." And then the 30% drawdown happens, and they freak out, fire you, and put all their money in gold, right? So it's like- Yeah. Can you actually do it when it happens is a question that, you know, we're always trying to answer for every investor. I always go back to, hey, as an investor, I'm worried about X, Y, or Z at this time. Okay, great, I get it, but three years ago, what did the market do? You're like, "I don't remember." I'm like, "You know, three years from now, you're probably not gonna remember what the market did." That's a really good point. Whatever serious thing is going on- Yeah. The crisis thing. You know, you freak out in the moment, but then you ask people like, "What was the crisis four or five years ago?" You know, I'm gonna, sorry, I didn't mean to interrupt. I wanna touch on one other thing that we didn't touch on, which is this idea of, you know, yeah, but sometimes, people are right. I mean, they go back to, you know, irrational exuberance in the early 2000s or "The Big Short" narrative of 2008. I'm sure somebody saw COVID coming and probably got outta the market. So there's success stories, but there's a great quote, and I can't remember who it was attributed to off the top of my head. One of you might remember. It's, "The market can stay irrational longer than you can stay solvent." And I love that quote, and I reference it quite a bit in my talks because, you know, these people that maybe get it right might have been saying that for years before they got it right, right? So you have, you know, the old saying goes, "Even a broken clock is right twice a day," right? Somebody who says the market's gonna crash, every year, they say the market's gonna crash, they're gonna be right. What about every six or seven years? Depending on how you define a crash. So be careful of those narratives. They're gonna sort of crystallize that hindsight bias 'cause that will also happen. And a lot fewer people are actually as right as you think they are than what the media might, you know, suggest it, it turns out. Well, let me ask you this, you mentioned sort of the survival instinct. Give us an example of what that means, and is that connected to then to chasing patterns? Do those things go together? Yeah, I mean, it's famously said, "How many data points does a human being need to extrapolate a pattern?" They only need two, right? Like where we are now, and give me one more data point, I'm gonna make an extrapolation. And that can go both positive and negative. But survival instincts, I mean, there's examples of this. You know, losing money feels like getting hurt, right? So there's a danger element to losing money. So our instinct is to, well, when if there's bad news, I'm looking for a signal, right? You talk a lot about signal and sort of outcomes. In the financial markets, we get a lot of negative signals. So we're constantly being thought, being taught, rather, that our survival is in jeopardy. So we're constantly making decisions to try to mitigate the amount of danger we're subject to. So that is why people sell too early, or they bail out on markets at the wrong times. They aren't able to stick to their plans. That's their survival instinct I'm talking about. I mean, we're here at Dimensional, right? We're a very sort of rational, data-driven, research-based firm. And a lot of our founding is sort of in the empirical camp of academia, right? But then you've got this behavioral camp that we're talking about today. I mean, in your opinion, are those kind of two broad areas? And then a question for you, how can they coexist? Efficient markets and behavioral finance, they've both been recognized in the academic community. There's Nobel Prizes on both sides of that debate. I don't look at it as a debate, right? I mean there's, the work on the empirical work on how markets work, and the data we see about like what price informs in terms of expected returns and stocks and bonds and securities around the world. That's all super useful. But the analogy I like to say is that tells you how to build a really good car for your journey. It doesn't tell you anything about how to drive the car. And so behavioral finance and psychological research into economics, that focuses a lot more on behavior and driving the car. So I tell audiences, I say, "You know, you gotta do both right." You can have the perfect portfolio, but if you don't stick to the plan, you're not gonna be, you're not gonna have a high likelihood of being a successful investor. Consequently, you could be a really well-behaved investor, but you have all your money in a single stock, right? You're very disciplined, you're very aware of your biases, but you don't have the right car. So, to me, getting both of those right is super important. I love what you said there about sort of the empirical camp and then the behavioral camp. And I think a lot of that also sets up where a financial advisor comes in, kind of this objective third party 'cause to your point, even if you know, even if we know that we have these things that are going on with our emotions, that are going on in our head, we have all of these biases, the ability to be aware of them, but then execute rationally in really tough times when things get choppy is really hard to do. I mean, that's the role of the advisor right there. Yeah, on that note, and I think that's a really important subject to bring up, as I'm going through the list of biases, there was one that kind of caught my eye, and I hadn't heard of it before, but it's called the GI Joe fallacy. And so there's this paper in 2022 by Harvard and Yale academics, and they get this, I'll give the punchline first. The punchline is, you know, being aware of these biases is a very small part of the battle. Like you have to have an ability, a plan to combat them or to sort of put them in check. And the GI Joe reference comes from a 1980s Saturday morning cartoon. I'm sure I watched it when I was a kid at one point, but I guess at the end of these episodes, they always had a PSA announcement, and it would say, "Now you know, and knowing's half the battle." ♪ T-I-I ♪ And these academics sort of like seized on that nostalgia and said, "Well, actually, knowing's not half the battle." It may be 10% of the battle or 5% of the battle, but the real battle is not knowing about it, because lots of people know about this stuff and still cannot help themselves when, you know, the you-know-what hits the fan, and anxiety levels are very, very high. So I love that, they sort of parse those into two different sections, right? There are certain biases that are sort of these encapsulated biases. And these are the ones, they're just hardwired. These are the survival instinct ones that you cannot get rid of. And then there's attentional biases, and attentional biases are ones where they're like illusion of control. You can do things to help yourself recognize when you're, you know, engaged in a bias like illusion of control. You're trying to control an environment that you really can't control. And you're spending a lot of time, effort, and possibly money, trying to control something you can't control. This is where an objective third party comes in. This is where a professional advisor who, amongst the laundry list of things they do for clients, managing their behavior is one of them. They can point that stuff out for their clients, and they do, all the time. We all have heard so many stories about advisors keeping clients from making really bad decisions at times of really high anxiety. Well, and to that point, I mean, we hear all the time, well, not all the time, but sometimes investors will push back and be like, you know, "Is this financial professional, is this advisor worth the cost?" Whatever that fee may be. And we know that you go back to March of 2020. You go back to the great financial crisis back in '08-'09, right? I mean, just keeping clients disciplined through one of those time periods is worth its weight in gold. And that fee is definitely justified. Well, you made a comment too that I thought was interesting early on about, you know, when our portfolio goes down, and we lose money, like it's almost a physical pain. And you're talking about this idea of, hey, we know stuff with our health, it doesn't mean we always do it. So I think this behavioral stuff is just as important in our day-to-day lives as it is in investing. Right, I mean this idea of there's overconfidence, loss aversion, we try to find patterns in life. It's not just investing, it's everyday, everyday living. If anybody played sports growing up, you know there's a reason there are sports psychologists because a lot of these biases you apply when you're there on the field, you're on the court, you're on the course, or whatever it is, right? I mean, all of this stuff, this is not just specific to money. These things are going on in our head every single day. Yeah, I mean it's how we're wired. I mean, we're human beings, which is, kind of makes this all inevitable. So having a plan for it is really useful. And it's what most advisors spend a great deal of time building. I was just thinking overconfidence, in relationships too, like I learned with my wife. Is this gonna be like marriage counseling, Doctor, what do you wanna unpack? I wish I go to bed, saying like, "Man, I am just killing it as a husband, feeling good right now." She's like, "What are you talking about? Like you're in the doghouse." Betsy's never said, she's never said, "You're killing it as a husband." I'm pretty sure not. In my mind. No, I mean, Ken talks about it a lot in his equilibrium markets narrative, where he says, "Overconfidence is the number one bias that shows up in all the literature." So it's kind of where everybody leads with. And I like to say, "You know, there's varying degrees. Some people have more of it than others." But, you know, kind of as, thinking about humanity, you know, you kind of want some people to have a lot of overconfidence. I mean, that's how we innovate, that's how we take risks, that's how we get, you know, we move ahead as a species, I guess, if you want to get really wonky. But, you know, so overconfidence is just part of, is part of the human condition, and some have more of it than others. There's no pill for it. We wouldn't want to take it even if we could. So I think it's okay, Mark, that you think you're a great husband, even if Betsy doesn't always agree. Well, thank you, Scott. Yeah, and you know what, when you think that way, you feel better, and a lot of this stuff is psychological defenses, not about survival. Some of it is about survival, but a lot of it's just, you know, when we make a bad decision, we have these psychological defenses that say, "Well, now that wasn't my fault. That was this externality, something over here caused me to make that bad decision." So that's called attribution bias. And then you also have the opposite, which is, you know, when you made those first option trades all those years ago, way before you were at Dimensional, you know, what did you think? You probably thought, "I am so smart." Yeah, absolutely. "Look at those great trades I made. I'm gonna be so rich if I keep doing this." So overconfidence is great, it makes us feel better, but it can, there's a different side to all these coins, and they can lead us into bad paths on an investment, and a marriage basis, if you wanna put it that way. Attributing the mistakes to externalities and the overconfidence sounds like stock-picking managers right there. Well, I guess you look back at it all, say, "It's absolutely help, of the literature and some of the biases, and everybody will have their own different biases, and then what do you do about it?" And you guys talked about that, you know, get some professional help, get an advisor, they do a lot for you, but also they're independent emotionally when it comes to either the greed side of it or the fear side of it, which we're talking about there. And then the last thing here, and I think Ken French, you alluded to him earlier, he does a nice job with this theme of don't evaluate the quality of your decisions by the outcome. Go back to the decision you made at the time of the decision. Did you make it with the information available at that time? Did you make the best decision you could make? And that's independent of the outcome. So I think that's helpful for investors too, to sort of anchor to that one as well. All right, well, thanks, everybody, for joining "The Informed Investor." We appreciate your time, and we will come back on a subsequent episode and talk about private credit. We are hearing a lot more about that in the headlines. We'll come back and talk about that in more detail. Thanks, everybody, have a great day.