Why Smart People Make Bad Investment Decisions (EP.258)

0:02We all need to make smart decisions with our money. The Long Term Investor podcast shows you how by distilling complex financial matters into easily digestible lessons. And now, here's your host, Chief Investment Officer at PlanCorp and the author of Making Money Simple, Peter Lazaroff.

0:21The Long Term Investor:Humans didn't evolve for investing. Our brains are built for survival. Notice a pattern, make a call and act. because on the Savannah, hesitation could get you killed. In markets, that same wiring pushes you to do the exact thing you're trying to avoid, react quickly to incomplete evidence, and mistake motion for progress. I think what makes this especially tricky is that intelligence doesn't fix the bias problem. There's a study that I'm going to link to in the show notes at thelongterminvestor.com, in part because I can't pronounce all the authors' names, but that study finds that cognitive ability doesn't reliably reduce susceptibility to bias.

0:59The Long Term Investor:And in fact, in many cases, smarter people simply just get better at defending their decisions, especially after the fact, even when those decisions were flawed. I've watched this play out time and again with incredibly smart people, engineers, physicians, attorneys, business owners, senior executives, you name it. They're used to having problems with a correct answer, or at least an answer that can be improved with more effort. But markets don't work that way. A confident forecast can be wrong and a tidy story can be pure nonsense. Factual statements can still be irrelevant to the decision at hand.

1:35The Long Term Investor:And that's how smart investors get themselves into trouble. They overestimate their ability to predict what comes next. They anchor on data points that are real but incomplete or irrelevant, whether that's performance over the wrong time period, evaluation statistics stripped of context, a geopolitical trend, a backtest that excludes taxes or costs or just the emotional difficulty of sticking with a strategy. Then they do what smart people do when they feel uncertain. They keep looking for more information. And I get it. Seeking out more information feels like the responsible move, because when evidence comes in shades of gray, as it often does in investing, it's easy to believe that one more article or one more chart or one more data point will finally turn uncertainty into a clear answer.

2:24The Long Term Investor:But more information doesn't always make you more accurate. Often, it just makes you more confident. There is a study in 1973, I'm probably going to butcher this author's name, but it's by Paul Slavik, who found that professional horse racing handicappers became more confident as they were given more information, even though their predictive accuracy barely improved. The researchers asked them to pick winners using five facts about each horse, and they were right about 17 % of the time. Then the researchers gave them 10 facts. Accuracy barely moved, but the handicapper's confidence jumped. At 20 and 40 facts, confidence kept climbing while accuracy stayed essentially flat.

3:03The Long Term Investor:And that's the trap investors step into every day. The extra data creates a sense of control even when the decision hasn't actually been improved. And at some point, information stops being input and starts becoming camouflage for something else. Now, I feel like I see this most often when someone tries to engineer the optimal portfolio allocation. They read every outlook, comparing competing forecasts and they build spreadsheets, tweak assumptions, and just keep refining the mix. The process looks rigorous. It almost looks scientific, but the inputs are guesses stacked on guesses. And the more variables you add, the more ways you can be precisely wrong.

3:46The Long Term Investor:Don't get me wrong, professionals do this too. I feel like I see it with capital market assumptions tables that will show expected returns to the second decimal place, as if we can forecast the next decade with that kind of accuracy. The honest part of those tables isn't the decimals. At best, it's the wide range of outcomes sitting behind them. Now, sometimes people also just overanalyze decisions that barely matter, like choosing between two nearly identical ETFs. Think about this, two ETFs with the same asset class, nearly identical fees, similar holdings, and yet investors will spend hours comparing five-year returns, trading volume, and tracking year trying to win a decision that doesn't have much to win.

4:29The Long Term Investor:Other times, people compare funds that were built for completely different jobs. And the work feels like diligence. I get it. But in reality, it's really just anxiety dressed up as analysis. And in many of these situations, the real issue is that the question is fuzzy. If you can't clearly define what you're trying to solve, whether it's lower cost, improved diversification, reduced taxes, managed volatility, whatever it is, you won't know which information matters. So I always tell people who are going through this exercise that sort of looks like analysis, but really is just market anxiety. I tell them to start by writing the decision in one sentence and then gather only the information that could realistically change your mind.

5:13The Long Term Investor:I mean, that's real diligence. Everything else is just motion. But here's the other tricky part. Markets don't give clean feedback. A careful decision can look wrong for years and a sloppy one can look brilliant. So that's why you need a process that not only guides what you research before you act, but also tells you how you'll judge the decision afterward. There's a term I really like that was coined by Annie Duke, a former professional poker player and World Series of Poker bracelet winner. It's called resulting, which she uses to describe the habit of judging a decision by how it turned out instead of how the decision was made.

5:50The Long Term Investor:So think about this in terms of poker. A reckless bet can win because the right card just happens to show up, whereas a well-reasoned bet can lose because it doesn't. And in poker, oftentimes the decision happens before all the cards hit the table, and then the outcome of the decision becomes clear. In many ways, investing works the same way, except the feedback loop is slower and the cards stay hidden for longer. You can buy a fund for a bad reason and still make money. and you can build a thoughtful portfolio and still underperform. It doesn't automatically tell you whether the decision was good.

6:23The Long Term Investor:And I think that's the trap. If you start treating outcomes as proof of intelligence, you'll reinforce whatever behavior happened to work most recently. And the stretches that test you aren't always just those one-year blips. I mean, they can run for five years, 10 years, 15 years, long enough that good investors start to feel foolish, impatient investors start to feel invincible. When making a decision and judging the quality of that decision later, it is essential to remember that we don't control the outputs. We only control the inputs. And those inputs are the things you get to choose. You can ground expectations in history.

7:01The Long Term Investor:You can count costs and frictions. You can decide what role each position plays. And you can size risk to something you can stick with when it gets uncomfortable. And perhaps most importantly, you can write down why you're making a decision before the outcome has a chance to rewrite your memory. Outputs are the realized returns over a year, over five years, over a decade. They're influenced by luck, timing, starting valuations, interest rates, inflation, investor behavior, and the path markets take along the way. I think the mistake is pretending that the output gives a clean grade on the input.

7:38The Long Term Investor:It really does not. A bad outcome does not automatically mean the decision was bad. And a good outcome does not automatically mean the decision was good. And I get it. That can be frustrating, but it can also be really freeing. It means you don't have to rebuild your entire philosophy every time the market hands you a disappointing year. And you shouldn't crown yourself a genius every time the market rewards a risky decision. I think this mismatch is why behavior does so much damage in the first place. It doesn't actually come from owning terrible investment. I think it comes from changing course at the wrong time, because red on a statement makes people want relief and green makes them want more.

8:18The Long Term Investor:Neither reaction tells you whether the original decision was sound. The answer cannot be just more confidence. It has to be process, because process forces you to ask, what am I trying to solve? What would change my mind? What risks am I taking? How will I know later whether this was a good decision? That is the answer to the problem we've been talking about this whole episode. Not more intelligence, not more information, not better storytelling after the fact, a better process. And that's exactly what I'm writing into my new book, The Perfect Portfolio. The book is not about pretending there's one perfect portfolio that fits every person, every market, and every moment.

9:01The Long Term Investor:That portfolio does not exist. The point is to build a decision process that's durable enough to survive real life. Those uncertain moments, those emotions, those market cycles, and all the temptations to change your mind at the worst possible time. Now, there's one essential component of the book that I call the probabilistic decision protocol or the PDP. The probabilistic decision protocol is structured in a way to slow down major investment decisions and leaning on evidence. And that way, when you go back and look at a decision, you can judge the choice, not just on the outcome, but based on the information you had at the time of the decision.

9:42The Long Term Investor:Now, I promise I am gonna go deeper into this protocol in a future episode. So I just wanted to introduce the general idea because if the topic resonates with you, if you've ever felt like you're working hard to make a good investment decision, but still weren't sure whether you're being disciplined or just overthinking, I'd love for you to follow along as the book comes together. You can receive updates about The Perfect Portfolio using the link in the episode description or by visiting theperfectportfoliobook.com. The list has been active for a few months now, and subscribers get early chapter previews and excerpts, behind-the-scenes stories from the writing process, and invitations to subscriber-only webinars where I'll go deeper on ideas in the book just like this one.

10:26The Long Term Investor:Because the goal isn't to feel certain. The goal is to make better decisions in the presence of uncertainty, and that is what a real investment process is built to do. As always, thanks for listening, and until next time, to long-term investing. Thanks for listening to the Long-Term Investor Podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan.

11:08This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.