MI Rewind: The Psychology of Money & Behavioral Finance w/ Daniel Crosby

0:00You're listening to TIP. On today's show, we're resharing some of the older episodes that are my favorites for a few reasons. One, we get a bunch of new listeners each week, so new listeners may not have heard this episode before. Two, even if you've been listening for a while, you may have missed this episode when it originally came out. Or three, even if you've heard it before, it could be a great episode to learn from again. If you've already heard this episode or you're not interested in hearing it, feel free to just skip it. There's no harm in that. And you can pick up with our new episodes next week.

0:31That's all I had for you for this new intro. Everything going forward is going to be from the original episode. I hope you guys enjoy it. You're listening to Millennial Investing by the Investors Podcast Network, where your hosts, Robert Leonard and Clay Fink, interview successful entrepreneurs, business leaders, and investors to help educate and inspire the millennial generation.

0:58Hey, everyone. Welcome back to the Millennial Investing Podcast. As always, I'm your host, Robert Leonard. With me today, I bring back Daniel Crosby. Daniel, welcome to the show. Thank you. It's great to be back. Our last episode together was episode 14 for anyone that's interested in going back and checking that out. But for those who are just hearing you for the first time today, Tell us a bit about yourself and your background. It's great to be back. I'm Dr. Daniel Crosby. I'm the Chief Behavioral Officer at Orion Advisor Solutions. In my work there, I really study money, mind, and meaning.

1:34I study how people make decisions with money. I study consumer psychology and all of the ways that we get sideways with money and how investors can make poor decisions and how we can design technology and even products to help them make better decisions. The quantitative side of finance has intrigued me for years and years, but lately I've been really enjoying learning about how psychology impacts money and investing, which is why I wanted to connect with you again. What exactly is behavioral finance and why does it have such a big impact on one's investing success? Well, behavioral finance is just, I think, the study of finance in a way that accounts for the messiness of the human condition.

2:19A lot of the old school models were based on this assumption of perfect rationality or people maximizing utility, basically people operating in such a way so as to always give the best result for them financially. And we know from our own experience, I think each of us can look at our lives and understand the ways in which that's not the case. So I think there's a couple of reasons why behavioral finance is so interesting and why you're right to be so interested in it. The first thing it helps us do is it really helps us hang on to more of our hard-earned cash. It helps us hang on to the more of the money we do have by avoiding these investment pitfalls that we'll talk about today.

3:03The second thing it helps us do is it helps us know how to spend and save it in a way that's really edifying, in a way that improves life and really gives us maximal happiness. And then finally, I think, and probably least appreciated is that it can be a path for self-exploration. It can be a way for us to get to know more about ourselves and our financial lives can actually teach us quite a bit about our personality and who we are deep down. And so I think all of those reasons are reasons to be interested in behavioral finance. Why has it taken so long for behavioral finance to become as mainstream as it is today?

3:42And why didn't academia accept it at first? You know, I think there's a couple of reasons. One is that we suffer from sort of this physics bias. Every discipline wants the sort of predictive and explanatory power that's available to us in the physical world. But of course, whenever humans sort of enter the loop, that's not really available to us. And so it sort of lacks the uniformity and the simplicity of some of those old school econometric models. And because of that physics bias, I think that maybe we were slow to see it. And then I think maybe the second and the more profound reason why we were slow to adopt behavioral finance is that it asks something of us.

4:29I'm a clinical psychologist by education, and I spent years in private practice meeting with people as a clinical psychologist, and people were always looking for the pill, right? They were always looking for the magic words or the pill or the whatever that would bring them out of whatever funk they were in. And it was my job to tell them that the process of getting unstuck was likely going to be arduous, that it was going to be imperfect, that there would be some back and forth, and that it would ask a great deal of them and that there was no pill, there was no magic word I could say. And I think that's what behavioral finance teaches us.

5:11It's not just about picking the right stocks. It's not about calculating a discounted cash flow or knowing what a PE ratio is. It really asks something and requires something of us in a way that is ongoing and is imperfect. And that's not as sexy as the sort of more mathematical approaches to finance. Back in March, you shared an awesome infographic with a summary of some of the most important money lessons. You said that if people can get these things right, they'll be okay. Talk us through the most important ones from that list. Yeah, that list is actually something a reader created. That list was from my first book, The Laws of Wealth.

5:51And so in that book, The Laws of Wealth, I set forth 10 commandments of investor behavior, I call them, which are just as you've described them. Try and pick some of my favorites. The first is that in every market, you control what matters most. That's the first chapter. That's where I wanted to really help investors take the power back, to help them understand that they were more powerful and more in control than perhaps they understood. it. Because I think when people find out that I work in finance, they do things like ask me about what's the president going to do, or what's the Fed going to do, or what's the debt ceiling going to do.

6:31And it's always sort of externalities. It's always things outside of themselves that they have no control over. And yet all of the research shows, making the right decisions, working with someone, automating your process, keeping your fees low. All these things that are within our power are really what's predictive of whether or not we reach the finish line. So I wanted to help people take that power back. The next thing I talk about in there is that diversification means always having to say you're sorry. What does that mean? We know we're always supposed to diversify. So how do I always have to say I'm sorry if you're diversified, there's always going to be something in your portfolio that's kind of sucking.

7:19There's always going to be something in your portfolio that's frustrating to you, at least on a relative basis, because it won't have done as well as some of the other screaming on fire portions of your portfolio. And we have to actually understand that that is a feature and not a bug. That's something that we should really be looking for in a well-balanced portfolio. And then the last one that I'll talk about is that excess is never permanent. One of the things that we do as a human race is we tend to extrapolate the present moment into the future indefinitely. So I meet you the first time we talk, you're intelligent, you're engaging, you're kind.

8:03So the second time I come back on your podcast, I go, okay, well, he's going to be all those things again, because I expect that history will repeat itself. Well, that's often true of people, that's often true of other things in our lives, but it's not true of markets. The truest phrase in investing is this too shall pass. And this phrase, this too shall pass, in a bear market, it gives us hope for the future. And in a bull market, it sort of chastens us and tells us to manage our risk. And so I wanted to break that sort of psychological trap of thinking that the future would always continue in the same vein as the recent past.

8:46So those are three of the 10. Whether it's one of those three, or maybe it's one of the other seven that we didn't talk about, which of the lessons on that list are the most common for people to fail at? Oh, goodness. I think in terms of failure, if I had to kind of pick a failure, there's one of those that we didn't talk about, which is effectively, you're not special, right? You're not different. You're not better than the next person. Because one of the things that we have to understand is that being a great investor really is contingent on us understanding all of the ways in which we're not that great of an investor and understanding that we are susceptible to all the same pitfalls and shortcomings as the next person.

9:33And it's only once we own that lack of specialness or own that lack of greatness that we are paradoxically able to be great. And that's really hard for people to do. We're good at kicking ourselves. We're good at saying, I suck. I shouldn't get started. And we're good at being self-aggrandizing. We're good at being overconfident, what we're not good at is this sort of measured middle ground of saying, yeah, I should do this. I should start this. And I'm no different than the next person sort of fundamentally. Kind of that balanced humility is nothing that humankind does very well. I've talked with a few guests about the relationship between money and happiness, but I think you have unique perspective or qualifications to really talk about the dynamic of happiness and money.

10:27So do you think that money can make people happy? And if so, how does it do it in a way that people might not think? So I'm going to introduce kind of a funny psychological term here. I kind of hate it, but it's worth knowing. The term is hygiene factor. So money is a hygiene factor. And what a hygiene factor is in psychology means that the absence of it will make you miserable, But a surfeit of it, like a surplus of it, won't necessarily make you happier. And that's exactly what money is. If you have no money, that is a truly miserable condition. You can't live in a safe place. You can't send your kids to a good school.

11:13You don't have enough to eat. The roof is leaking. The absence of money can rob us of an immense amount of happiness. But a mountain of money won't make us much happier than adequate money. We find that that satisfaction and happiness around money plateaus at a relatively low base. And so money, will it buy happiness? Eh, kind of. We can talk about a few ways that it does in a moment. Mostly what it buys, though, is the absence of misery. That's worthwhile. I think more so than sort of maximizing happiness in the world, we want to minimize suffering. And money does a very good job of minimizing suffering.

11:59Now, when we look at the research around where money does buy happiness, there's really basically three ways. One is getting you out of stuff that you hate. So if you hate whatever, washing your car, cleaning your house, cutting your yard, Paying someone money to get out of doing things that you hate absolutely brings you happiness. The other thing is using that money to buy experiences with people you love to spend time with, that buys happiness. Those experiences can contribute to legitimate happiness. And then finally, we know that giving money away also can bring a great deal of happiness.

12:40So aside from those three ways, money does not buy happiness, I think in the ways that we conventionally think like a big house or a big car. What have you found to be that threshold? You mentioned there's a relatively low baseline. I've heard things like 70 ,000 in annual salary. I've heard that that might be a moving goalpost, like it might change. So what do you think is that baseline? Sort of the seminal research that was done on this was done by a Nobel Prize winner at Princeton, and he found that it was about 75 ,000. And it's not that there's no happiness to be found after$75 ,000, it was that it plateaus quite significantly.

13:20So if you look at the difference between someone who makes$5 ,000 and$50 ,000 in terms of their happiness, it's enormous. The person who makes$50 ,000 is enormously happier than the person who makes five. But if you look at the difference between someone who makes$50 ,000 and$500 ,000, it's quite different. Newer research says that that number may be a little bit flawed, but I think whatever the number is, it's what's the number that it takes for you to live in a safe home, provide for your healthcare needs, provide for your children, and put food on the table. That's effectively what money can do.

14:01It's going to look different from geography to geography, but if you can do those things, and I don't mean send your kids to private school. I don't mean live in a seven-bedroom house. And if you can provide for the necessities of life, and you've got that much money, you've got about all the happiness you can buy with money, aside from those three very particular things that we talked about. Let's take a quick break and hear from today's sponsors. Even Einstein had blind spots. That's why modern science is built on the idea of peer review. Investing may be more art than science, but that doesn't make peer feedback any less valuable.

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17:15And for a limited time, you can use code stocks15 for a 15 % discount at checkout. All right, back to the show. I was going to say, it's probably very geographically dependent, right? New York City versus somewhere in the middle of Iowa or Idaho is probably going to be significantly different. Sure. There will be certainly some differences based on the purchasing power of your dollar. What do you see as some of the most common misconceptions that surround money and how people think about money and psychology today? For me, the biggest one has to do with the idea that we'll ever have enough. I think a lot of people, I know I do, have a number.

17:56Here's my number. This is my fire number. This is my retirement number or whatever. What I've observed both in the research and in my own life is that when you approach that number, it's no longer the number anymore. You continue to move the goalposts. And if you're not careful, you live this life of sort of, I'll be happy when, and you end up never living. So I think we are just not wired for adequacy. I mean, we're wired for striving. We're wired to keep putting one foot in front of the other. And so the idea that you have enough money is contrary to that, and it's hard for people to grasp. And one of the reasons why is this idea in psychology called the hedonic treadmill.

18:46If you think of the word hedonism, that's the pursuit of pleasure. And then of course, a treadmill where you're just running and running and staying in the same place. The hedonic treadmill says that as you make more money, your tastes and what you consider a necessity will rise alongside that increased wealth. So I eat very differently at the age of 42 than I did at the age of 22 when I was in college. And if I had to go back to the way I then, if I started having ramen for dinner every night and Hot Pockets, I would be upset. It was perfectly fine for me at the time. It was consistent with my place in the world.

19:29It was consistent with my peer group. But after you've been eating steak for a few years, it's hard to go back to the Hot Pockets. So our expectations and our tastes tend to rise alongside our income. And it's hard for that not to be the case. How do we keep that in check? How do we make sure that it doesn't grow faster than our income, or we don't get stuck keeping up with the Joneses on the way up? And then once, let's say we hit that number, we make as much money as our goal is, or we've saved as much as we want. How do we stop that fuel post from moving? I think it's always going to move a bit.

20:05I think you can keep it from moving sort of gratuitously. And I think a couple of the ways that you do that are, first of all, you lock in higher savings percentages with higher incomes. You do what's called save more tomorrow. So when you're making$50 ,000 a year, you're saving 10%. You automate the process of saying, well, when I get bumped up to$75 ,000 a year, I'm going to save 15%. And when I get to$100 ,000, I'm going to save 20%. So your income's rising, yes, but your saving is rising right alongside of it. So I think you should, as your income rises, you should become more and more aggressive with your saving and your investing and give yourself this feeling of artificial scarcity, have it never hit your account, have it go straight to your saving and investing account so that it's not like it's really there.

20:59And then the second thing I think you have to do is examine, do a deep dive on the reasons why you spend the way you do. All of my personal spending habits are things I couldn't afford when I was a kid. I want to buy shoes, guitars, and baseball cards. At 41 years of age, I'm over here buying the Jordans I couldn't afford when I was 10 years old. And that's fine if I can afford it, but it's also me trying to scratch a psychological itch that I might not be able to scratch in that way. So I think if you understand the reasons why you spin the way that you do and the psychological needs that you're trying to get met, I think oftentimes there's going to be a more direct way to meet those needs than buying something.

21:54On Twitter, you shared another infographic I liked about picking individual stocks. It walked the viewer through a series of yes, no questions to help them decide if they should buy individual stocks or not. Talk us through that framework and some of the questions that should be asked before buying individual stocks. I know what you're talking about. I actually deactivated my Twitter account this morning, so I can't pull it up, but I can walk you through how I think about picking individual stocks. First of all, all of the research shows that it's a very hard game. There's research out of Taiwan to show that one in 360 day traders, individual stock pickers show levels of skill that are any appreciable level of skill.

22:43We know even in a professional context, that these fund-to-fund stock, these folks that are picking different horses to bet on, if you will, different asset managers to bet on. Only about 5 % of them show skill. So I think if you want to engage in stock picking, you have to do it in a very particular way. And I give it my three C's. So my first C of stock picking is consistency. You need a rules-based, systematic, robotic approach to picking stocks. It doesn't need to be whatever's blowing up on Twitter that day. It doesn't need to be whatever your friends are talking about or whatever the meme stock du jour is.

23:28You need a systematized process, whatever that looks like. And we'll talk about a few of those in a minute. And you need to stick to those rules in good times and bad. So the second thing you need is clarity. There are a million different ways to invest your money prudently. You can be a momentum investor, you can be a growth investor, a value investor, indexer. There's many different ways. All of them make money over the long term. But you have to know what your religion is. You have to know your faith. You have to know your signals. And again, you have to stick with those signals in good times and bad.

24:07So for me, a signal needs to pass really a three-part test. It needs to show up in the data. We need to see that the numbers back it up. There needs to be good theory behind it. And it also needs to have a behavioral component to it because there's this long history of folks discovering different stock anomalies, like calendar effects and different things. But if there's no behavioral component to them, If there's not a reason why it's hard to do, then it tends to disappear. So something like value investing has a behavioral component to it. It's hard to buy stocks that are on sale because necessarily they look cheap.

24:53And so we sort of tell ourselves that they're no good. So the data is there to back up value investing as a system. The theory is there, and there's also a behavioral reason why it works. And then the final C is conviction. you need to find the sweet spot between diversification and conviction. Because if you are going to pick stocks, if you're going to bother to pick stocks, we know that we need to diversify, right? But we also know that if you're going to bother to pick stocks, you need to have enough conviction in what you're doing to have it look different than an index fund, or else you should just go buy the index fund, right?

25:31Because that's a very prudent way to invest. So you need to find that sweet spot between not taking an overly concentrated bet and having it be different enough than an index fund that it's worth your time. So consistency, clarity, and conviction are really the three things I think you need if you're going to pick stocks. Given how active and involved you were on Twitter, I have to ask, why did you deactivate your Twitter account? Robert Leonard Compliance. I work for a large financial institution. Compliance kind of makes it no fun. That's the reason. You got to run everything through compliance and you just lose some of the spontaneity.

26:11So it's just hibernating. I'll be back one day, but it's just sort of sleeping for now. But I haven't lost my followers or anything like that. Robert Leonard I was thinking it had to be either compliance or you're just spending too much darn time on it and you were like, I need a break. Like there's probably a bit of that too, but it's tough compliance sometimes can get in the way of sort of the quick back and forth that makes Twitter worthwhile. So would you say that the best alternative strategy to individual stock picking for most people is to just buy a low cost diversified index fund? Oh yeah.

26:47You got to think about the value of your time too, because let's say you have a $200 ,000 account, and you're able to add 1 % of alpha to your account each year through your stock picking, which by the way, would be incredible and somewhat rare, you're still making less than minimum wage. If you're spending a couple hours a week on this, you've got a$200 ,000 account and you're consistently adding alpha, which again, is not a given. You got to think about what's the opportunity cost of that time, because your brain and your body and your effort is really the engine of your wealth. So 99 times out of 100, you're going to be much better off just doing something low cost and diversified and taking that couple of hours a week and whatever, teaching a course, writing a book, getting a second degree, starting a side hustle, doing a million things are going to get you more money than actively managing your account.

27:47How do we get out of this mindset of having to pick individual stocks? Maybe it's not even individual stocks. Maybe it's just FOMO events. Maybe it's Bitcoin. Maybe it's the most recent IPO. Whatever the situation is, NFTs currently are going crazy, things like that. How do we really stick to, from a behavioral finance or psychological perspective, how do we really stick to our investing principles and try to forego some of these other FOMO events? Robert Leonard Well, I'll speak to my specific approach to that because I love markets. I love trading. I love individual stocks. I love taking a bet on an individual name.