An interview with Dr. Daniel Crosby On Behavioral Finance: The Laws of Wealth
Which behavior or behavioral trait do you think is the most damaging for investors and their returns?
One of the shortfalls of previous works on behavioral finance is that they present lists of investor biases with no organizing framework. At my last count, there are over 117 cognitive errors enumerated by psychologists that can negatively impact the investment decision-making process. It’s an impressive list to be sure, but telling the average investor, “Hey, there are 117 ways you can screw this up” isn’t exactly helpful. One part of The Laws of Wealth of which I’m extremely proud is the chapter that outlines a taxonomy of behavioral risk. Basically, I took the existing lists of biases and tried to organize them by their underlying psychological construct. This reduced the 117 to 5, a much more manageable universe. In my estimation, the five primary types of behavioral risk are ego, emotion, conservation, attention and information.
What sort of process or strategy do you believe is the best for investors to follow to minimize the risk from poor decisions driven by psychology?
In the book, I outline a middle ground between traditional notions of passive and active investing that I refer to as “rules-based behavioral investing” or RBI. I also set forth four pillars of behavioral investing: consistency, clarity, courageousness, and conviction. Consistency means systematic (i.e., discretion-free) decision-making. Consistency frees us from the pull of ego, emotion and loss aversion, while focusing our efforts on uniform execution. Clarity is all about simplicity. We prioritize evidence-based factors and are not pulled down the seductive path of worrying about the frightening but unlikely or the exciting but useless. Courageousness is all about automating the process of contrarianism: doing what the brain knows to be best but the heart and stomach have trouble accomplishing. Finally, conviction which helps us walk the line between hubris and fear by creating portfolios that are diverse enough to be humble and focused enough to offer a shot at long-term outperformance. Of all of these, I feel that consistency is the most important. Whatever rules investors choose; they are almost always better off following them than relying on their hunches in the moment.