The disposition effect is the tendency that
all investors have to sell their winners and hold their losers. We sell stocks that have appreciated and we
hold the ones that have disappointed us. The problem, Clay, here is that it’s not
that we’re making some sort of thoughtful decision. We dress this up as discipline. Welcome to the Millennial Investing Podcast. I’m your host, Clay Finck. Today, I’m joined by Scott Nations. Scott, welcome to the show. Scott Nations (02:07): Thanks so much, Clay. Clay Finck (02:09):
Now, Scott, I recently had a chance to read your new book, The Anxious Investor. I wanted to bring you on the show to chat
about it because I just really enjoyed reading through it. You talk about these bubbles. You talked about biases that we can have as
investors. I found it really interesting how you only
have four chapters in the book. Clay Finck (02:29): In the first three chapters, you talk about
three bubbles that have occurred throughout history and pull some lessons from each of
those. Before we dive in to talk about some of the
biases, what are the three bubbles that you cover in your book, and what led you to covering
these three specifically? Scott Nations (02:45): Thanks so much. The three bubbles and subsequent crashes that
I talk about are, the first one is the South Sea Bubble, happened in London in 1720. The second one, which everybody has lived
through, or almost everybody lived through is the internet bubble, which really reached
its peak in 1999. Then the most recent bubble I talk about is
the housing bubble and the subsequent stock market crash in 2008 and 2009, and every one
of your listeners is going to have lived through that. Really, the goal of the book is to help people
understand what’s going on in the market and what’s going on in their brain, literally,
when the market’s having a tough time like it has recently, and when they are anxious. Scott Nations (03:27): Rather than talk about these biases and say,
“Hey, Mr. or Mrs. Investor, you’re doing this wrong” or “You’re doing that wrong,”
the goal of the book was to talk about these three bubbles and crashes, and then in the
context of that, talk about some of the biases, illustrate the biases in a little bit less
threatening way, or a little bit less insulting way than simply saying, “Hey, you’re human
so you’re screwing up, and this is how you’re screwing up.” The goal is to allow people to see the biases,
understand it a little bit more, and also understand which ones they are most likely
to fall for. Scott Nations (04:01): We don’t all for every one of the biases. The ones that we do fall for, we fall for
to varying degrees. 1720, the South Sea Bubble, one of the very
first stock market bubbles, and it’s just fascinating. Again, it illustrates a number of the biases. The 1999 internet bubble, quintessential bubble. Then 2008 and 2009, that’s a bubble also,
and it led to a crash. The point there is, again, that people lived
through that, and hopefully, they have just a little bit of perspective now on what it
was like for them, and maybe that offers the opportunity for them to, again, put everything
in perspective and realize where they did well and where they did not do so well. Clay Finck (04:45): You open the book to talk about the South
Sea Bubble. I, personally, did not know a lot about this
going into reading the book, and just found it, like you mentioned, just so fascinating. You talk about how people can confuse investing
with speculation, or maybe in this case, we could call it gambling. Clay Finck (05:03): You mention that these people cloaked what
I would call a total gamble, and dressed it up as an investment. What are some of the telltale signs we can
look for, as investors, to quickly figure out if something is truly an investment or
is purely speculation? Scott Nations (05:20): One of the biases that every human falls for
is sensation-seeking. It’s the tendency, Clay, to engage in things
that are risky, not necessarily dangerous, but risky, or that generate some sort of special
sensation and we do it simply for the thrill of it. Perfect example is roller coasters. Another example, for some people, are horror
movies. Unfortunately, for some people, it’s illicit
drugs, and for a lot of people, it’s gambling, particularly casino gambling. Unfortunately, people sometimes trade in the
stock market, not invest. Not long-term investment, but they sometimes
trade in the stock market for the sensation of it, the thrill of it, the enjoyment of
it. There’s actually some really interesting
research in this regard. Scott Nations (06:01): As an example, there’s some research that
correlates and shows that, in one study, people who got more speeding tickets placed more
trades in the stock market. What that means is you’re placing those
trades not as part of some sophisticated, disciplined, long-term investment strategy. They’re gambling. They’re essentially gambling. Instead of going into a casino, they’re
using the stock market. Scott Nations (06:23): There’s another really interesting one from
Taiwan. Taiwanese people love to gamble, but casino
gambling is forbidden. There aren’t any casinos in Taiwan. A few years ago, the government started a
lottery. The kind of lottery that many of us here in
the United States are familiar with. Well, once Taiwanese investors had the opportunity
to express their sensation-seeking through the lottery, trading on the Taiwanese stock
market fell by 25%. Scott Nations (06:50): Finally, and this is a really interesting
one for me, given that I’m in finance myself all day, every day. Hedge fund managers who drive sports cars
underperform hedge fund managers who drive minivans. We know what’s going on there. How do we short circuit this sensation-seeking? How do we either identify it in ourselves
or thwart it, once we realize that, yeah, this is something we fall for? Scott Nations (07:15): Part of the book is to be honest with yourself. Go through, read about the biases in a nonthreatening
way, and maybe somebody will say, an investor will say, “I don’t fall for that one so
much. Don’t fall for this one so much, but this
one, that’s me. I fall for that one.” For you, that is sensation-seeking. Scott Nations (07:32): Then this is the suggestion I would have before
placing a trade. Wait 30 days. Just wait 30 days. If it’s a real trade, if it’s an investment,
30 days is going to be meaningless in the long term. On the other hand, if that irritates you so
much, the idea of just waiting for a little while irritates you so much that you can barely
stand it, then that trade is sensation-seeking. It’s a gamble and it’s not an investment. Clay Finck (07:58): I really like that. I love the example you give of the managers
who drive the sports cars underperform the other managers who live a more modest lifestyle,
essentially. It reminds me of two investors that people
talk about all the time, and that’s Warren Buffett versus Cathie Wood. It’s not to say that Cathie Wood isn’t
a great investor. Clay Finck (08:19): It’s just that many of the companies that
she was involved with, for example, Tesla, there’s just so much hype behind these companies
that either don’t produce a lot of profits, or just have a lot of hype and social media
attention that focuses around them, so I like that example you give. It reminds me of these two different investment
styles that seem to butt heads against each other. I just find it so interesting. Scott Nations (08:42): Warren Buffett obviously has a number of really
wonderful quotes about investing. The comparison you just made is tailor-made
for one of those. Warren Buffett has famously said that, “The
stock market is a vehicle for moving money from the impatient to the patient.” The impatient people end up transferring their
money, giving their money to the patient investors. I think that we know which one Warren is,
and I think we know which one Cathie Wood is. Clay Finck (09:08): You also talk a lot about risk in your book
and how certain people are able to take on maybe a little bit more risk than others. What types of investors are maybe able to
handle taking on more risk? Scott Nations (09:23): This is a really interesting question because
we often talk about reward in the stock market, that is how much we make. We probably don’t talk enough about how
much risk we take. Somebody’s earned, made 20% in the stock
market in a particular year, and the stock market’s only up a fraction of that, you
have to ask, how much risk were they taking? Let’s talk about individuals and risk-taking. It’s not so much that people should take
more risk or less risk, other than the obvious demographic situations. Scott Nations (09:52): My point about risk-taking is that, take the
amount of risk that’s appropriate for you, but realize that risk is the price you pay
for the returns you get in the stock market. If you think you’re going to invest in the
stock market and earn 7 or 8% a year over time … That’s about what the U.S. stock
market has returned since indexes started measuring returns in the late 1800s. If you expect to earn 7 to 8% a year, sometimes
you’re just going to be along for the ride. That’s kind of what’s going on right now. That is risk. Scott Nations (10:25): You don’t have to embrace risk, but you
have to recognize it. Don’t think that you can short circuit risk. There’s a famous Peter Lynch quote, that’s
the long-time, famous Fidelity mutual fund manager. He said, “The secret to making money in
stocks is to not get scared out of them.” It’s not so much about taking risk. I think it’s just about investing, continuing
to invest, and not trying to get out of the market or time the market. If you cannot sleep at night … This is an
old cliché. If you seriously cannot sleep at night, it’s
not so much that you have too much risk. I think you’re thinking about the stock
market incorrectly. Scott Nations (11:03): We’ll talk in a little bit about another
bias called recency. Really, recency bias is the tendency for us
to think that what’s going on right now is normal. Often, and right now is an example, it often
is not. Have the right amount of risk, but if in a
situation like this, you can’t sleep, then you’re probably just thinking about risk
wrong. It may not be that you have too much risk. You’re probably just thinking about risk
wrong. Clay Finck (11:29): In this chapter covering the South Sea Bubble,
you mention how one of the early investors in the company ended up selling out at a handsome
profit. You mention this term, the disposition effect. Walk us through what this means exactly and
why investors are susceptible to this. Scott Nations (11:48): The South Sea company had this really mundane
business, and that is they essentially were a clearinghouse for government debt. They paid a six pound sterling annual dividend. The price of the stock hovered around 100
pounds, so it generated about 6% a year in return, and it was very, very steady, very
mundane. People thought that this really obscure franchise
they had in doing business, trading business with South America, was going to make the
company incredibly valuable, even though most of its business was incredibly mundane. Scott Nations (12:21): It went for about 120 pounds early in 1720. Jumped to 300, then to 500. At one point, an old man who invested in South
Sea shares because it was, again, this mundane, very predictable investment, he saw it go
from about 120 to about 350. He thought, “Okay. This is enough for me. I’m going to sell,” and he sold. Sold at about 350 pounds a share, and then
got carried away. He saw it jump from 350 to 500, and then to
700, and then to 900, and he couldn’t stay out. Just could not bring himself to sit on the
sidelines, and so he got back in. He bought back in at the high. Scott Nations (13:01): Clay, your question’s about the disposition
effect, and it’s a fascinating bias that we fall for. What is it? The disposition effect is the tendency that
all investors have to sell their winners and hold their losers. We sell stocks that have appreciated and we
hold the ones that have disappointed us. The problem, Clay, here is that it’s not
that we’re making some sort of thoughtful decision. We dress this up as discipline. We think, “Oh, I’m taking a profit. I’m refusing to be greedy.” Pat myself on the back, “This is wonderful.” Scott Nations (13:37): On the other side of it, we refuse to sell
those shares that have disappointed us. We pat ourselves on the back again and we
say, “Oh, this is wonderful. Look. I’m refusing to be impatient. I’m going to stay invested, and I’m refusing
to be impatient.” Pat myself on the back. Well, that’s not really what’s going on. What we’re doing is, actually, we’re being
greedy in the extreme. How is that? When we sell our winners, we are greedy for
the swirl of chemicals that go off in our brain, that are fired through our brain, only
when we actually sell a winner. Scott Nations (14:09): I talk about this in the book. Having an appreciated stock, owning it and
continuing to own it doesn’t do us any good, as far as our brain chemistry is concerned. We actually have to sell the winner in order
to get that wonderful, pleasurable swirl of chemicals in our brain. We’re being greedy for that feeling. We’re not necessarily being greedy for the
money. We’re being greedy for that feeling. Scott Nations (14:29): On the other side, we’re trying to avoid
regret when we refuse to sell a loser. It’s not like we’re being disciplined
and patient. We’re being greedy because we want to avoid
that horrible feeling of regret. That’s the disposition effect. Again, I think the real danger there is that
we can trick ourselves into believing that we’re doing the right thing. “I’m refusing to be greedy, and I am being
patient.” That’s actually not what is going on there. Scott Nations (14:54): Final point here is Professor Terrance O’Dean
at Cal Berkeley, he’s a wonderful guy, and has written about a number of these in an
academic setting, shows, proves, quantifies the fact that when people give into the disposition
effect, the stocks that they sell ultimately outperform whatever they end up buying. If you get into the disposition effect, you
actually will end up underperformance, because what you sell ends up doing better after you’ve
sold it than whatever you continue to hold or what you buy with that money. Clay Finck (15:25): This falls in line with that idea that your
winners tend to keep on winning, right? With this one story of the South Sea Bubble,
many of the biases you discuss tie right in with this one story, which leads me to bring
up loss aversion, as the disposition effect refers to the tendency to sell winners and
hang onto losers, and loss aversion refers to people really disliking investment losses
much more than they feel good about investment gains. Scott Nations (15:54): People hear about loss aversion and they think,
“Oh, I should be averse to losses.” Nobody likes to lose money, and that’s absolutely
true, undeniably the case. When we talk about loss aversion, when I write
it, it’s not really that we dislike losses. We should dislike them. It’s that we dislike them so much more than
we like a similar gain that it really perverts our thinking. There’s some wonderful research by some
Nobel Prize winners who talk about this. Again, they’ve studied this. They do social experiments. Scott Nations (16:25): It turns out that we hate losses about two
times to two and a half times more than we like the exact same gain. Okay. That’s a human quirk. To a certain degree, this one makes a little
bit of sense because if you think about it, every time you lose a dollar, each remaining
dollar becomes a little bit more valuable. That makes a little bit of sense. As you gain a dollar, each dollar you gain
is less valuable than the one before, so it makes a little bit of sense. It really perverts, again, the way we think
about risk. Scott Nations (16:56): The problem when it really manifests itself
is that if the market’s having a tough time, and if it’s in a bear market like it has
been part of 2022, what happens is people get to the point where they just physically
can’t stand to lose any more money. They think, “I physically can’t stand
it. I got to get out of the market, even though
I’m going to be taking a loss,” and they sell. The problem is that they tend to sell at the
bottom. Scott Nations (17:19): There’s some really wonderful mutual fund
data from 2008 and 2009, and the biggest net mutual fund, equity mutual fund outflows in
decades happened in February and March of 2009, which was the absolute bottom of the
market. It was, people had seen what had happened
in 2008. The market just had a horrible year in 2008. There was never a day in 2008 when the stock
market closed higher on the year. Every single day, it was lower on the year,
and so now they get into February, March of 2009, and it keeps going down, and they just
can’t stand it anymore, and so they sell at the very bottom. The problem is, they don’t get back in until
it’s rallied a bunch. The reason they sell at the bottom is because
of loss aversion. They just can’t stand to lose anymore. Clay Finck (18:09): With all of these biases in your book, each
of us, individually, need to learn and understand these and try and figure out which ones apply
to us more than all the others. Because there’s a number of them, and not
all of them are going to directly apply to us in the same way, at least. What biases are you most susceptible to? Scott Nations (18:31): I spent 25 years as a professional option
trader on the floor of the Chicago Mercantile Exchange. I was that guy, for a long time, in a bright
red polyester jacket, jumping up and down, and so I got to see all the biases. I experienced all of them myself, and I got
to see them in others. The one that I fall for the most, by far,
is overconfidence. Human beings are overconfident in nearly everything
that makes us human. We’re overconfident. Scott Nations (18:56): For example, a bunch of research has been
done just comparing one college roommate to another. We are confident that we’ll make more money
than our college roommate, that we’ll have brighter kids, that we’ll be less likely
to have health problems, that we’re less likely to be a victim of violent crime. Now, some of that is out of our control, but
we are overconfident, nearly every way imaginable. When it comes to finance, we tend to be overconfident
about our ability to trade. Not invest, but trade profitably. We’re overconfident about our ability to
construct a good portfolio that is a portfolio that’s sensible and diversified. We’re overconfident in our ability to get
out of stocks at the right time. Scott Nations (19:36): The interesting thing is that it’s relatively
easy to know who’s most susceptible to overconfidence. Men are more overconfident than women. If men are stupid when it comes to overconfidence,
then single men are really stupid because they’re more overconfident than men in general. Overconfidence just really confuses you, tricks
you into thinking that you are a better investor than you are. Clay Finck (20:00): Yeah. I think there were a lot of people, even me
included, in call it late 2020, and during 2021, where everyone’s a genius. There’s that phrase, everyone’s a genius
in a bull market, and everyone’s overconfident that they can pick the winning stock and the
next winning trade. Even if it’s a beginner investor that doesn’t
even understand the basics of valuing a business, you can see that many of these people are
really overconfident in their ability to pick the winners and pick that right trade, just
because they hit big on this one idea they read about on the internet the week prior. Scott Nations (20:35): Right. We see this with meme stocks. We have a number of interns at the business,
and they tend to be younger. When it comes to the meme stocks, whether
it’s GameStop, or AMC, or some of the other ones, they were incredibly overconfident about
the potential for loss. That is, the stock’s going to go to $1,000,
literally without any consideration the opposite might happen. Again, we’re overconfident in nearly everything. Scott Nations (21:02): The Nobel Prize-winning psychologist/economist
Daniel Kahneman, famously said that of all the human biases, overconfidence is the one
that he would do away with if he had a magic wand. He said it’s the one that hurts us the most,
and he would do away with it if he had a magic wand. He then also went on to say, but it is so
ingrained in who we are, so threaded through our personality that you would end up changing
many, many, many things about who humans are. It’s fascinating that he sees it as the
worst or the most destructive of the biases. Clay Finck (21:39): Now, in the second chapter of the book, you
walk through some of the things that were happening during the tech bubble. I was personally fascinated with how people
would become emotionally attached to these companies and their founders. Back then, it was the early days of Apple,
Microsoft, and Google. It reminds me of how people view Elon Musk
today. Could you talk a little bit about this emotional
attachment that people had to the founders and their businesses, and how that maybe ended
up hurting investors? Scott Nations (22:10): This was really fascinating to me to learn
about it in order to write the book. Most of the research, academic research in
this regard has been done by two British professors, Tuckett and Tarfler. They call the phenomenon phantastic objects. In other words, people believe that some of
these products are just so wonderful, and some of the founders of these businesses are
so iconoclastic and interesting that people think that if they use the product or buy
the stock that some of what makes those people fascinating and interesting will rub off on
them. Scott Nations (22:46): People would look at Apple, at Steve Jobs,
what a story and what a personality, and so they would buy Apple stock, not necessarily
because they thought that Macintosh was going to be a big hit. It obviously was, but they thought, “Steve
Jobs is just so fascinating, I want to be in business with him. Maybe some of what makes him fascinating will
rub off on me.” Bill Gates is another example, to a lesser
degree. Scott Nations (23:10): The problem is, Steve Jobs never knew that
I owned Apple stock. He never knew, he never cared, he never called. We never went out for lunch together, and
he’s not going to know that you own. He wouldn’t have known that you owned it
either, so you’re right. People get carried away. The psychological term is transported by this
relationship. Scott Nations (23:31): I think it’s going on right now with Tesla
and Elon Musk because, let’s face it. He’s fascinating, he’s iconoclastic. He doesn’t seem to care about what anybody
else thinks. People swear by their Teslas. They love the technology. If you think Tesla, as a company, is going
to end up being really, really, really successful, then buy the stock. If you want to buy Tesla stock because you
want to be a little bit closer to Elon, well, that’s not a very good reason to be buying
the stock. Clay Finck (23:59): I found this chapter on the tech bubble really
interesting. You talked a lot about too, how many of these
tech companies were foregoing their profits just to really show the investors that they
didn’t want to earn a profit today. They wanted to build out their network effect
and get ahead of all the other companies on this tech trend. Clay Finck (24:18): It just felt like, during this tech bubble,
all rules of investing and valuing a company were just thrown out the window, and all rational
investing was just thrown out the window. I just found that so interesting how profits
didn’t matter anymore. It just rings so true with some of the things
we saw in 2021. Scott Nations (24:36): It’s a wonderful point. It’s almost not that profits didn’t matter. There are a couple of companies that I write
about that the leadership believed that if they showed a profit, investors would hate
that. The investors would say, “Oh, leadership,
sufficiently interested in growth.” Ultimately, a company has to show a profit,
or they’re not going to be around anymore, and so a lot of the companies in the internet
bubble lost sight of that. Every company has to invest, and sometimes
that means you less profit or no profit, but at some point, you have to have a path to
profitability. Scott Nations (25:08): Just getting big is not a strategy for profit. Some of the companies that fell for this approach
are the ones that we joke about now. Pets.com is a perfect example. They didn’t want to make money. They wanted to get big, even though they were
losing money on every bag of dog food they sold and shipped. You’re right, and you put it really well. People lose track of the way to value a company. Scott Nations (25:33): A wonderful example in the internet bubble
was that if a company that had nothing to do with the internet, and had no plans to
have anything to do with the internet changed their name to reflect something to do with
the internet. Joe’s Diner. If Joe’s Diner was publicly listed and changed
its name to JoesDiner.com in 1999, its stock price would rally, and that rally would be
sustained. That is, it wouldn’t come back to Earth. There’s a wonderful paper about this effect,
and you’re right. Changing your name has no impact on your long-term
prospects, but investors were just so carried away that if Joe changed the name of his diner
to JoesDiner.com, then the stock would go up the next day. Clay Finck (26:17): Probably one of my favorite biases that you
wrote about was the recency effect. This definitely plays into the South Sea Bubble
and what that investor did that ended up jumping back in after he sold his shares, but definitely
plays into the tech bubble as well, where the recency effect essentially outlines how
people will extrapolate whatever has happened in the last, say, three or six months. If stocks have been going through the roof
the last three or six months, people just naturally extrapolate that and assume that
will continue. Clay Finck (26:45): The same thing plays to the downside in that
how you mentioned earlier, how the max capitulation happens at the bottom when there’s that
max pain. People are just like, “I’ve had it. I’m not going to have anymore losses. I’m just going to sell before it goes down
even lower.” People will extrapolate the returns to the
downside as well. I just think the recency effect is one of
the biggest biases I think investors should be aware of. Scott Nations (27:09): I think you’re absolutely right. It would be easy for an investor who’s listening
to say, “Well, yeah, because if goes down tomorrow, it’s more likely to go down the
next day.” In the book I show, I detail, since the creation
of the Dow Jones Industrial Average in 1896, that what happened today has no impact on
what’s going to happen in the stock market tomorrow. I know that that’s tough for people to believe. Scott Nations (27:34): It’s so counterintuitive, but there is no
impact from today’s action on tomorrow’s action. There just isn’t, and so if you insist on
believing that what’s happened recently is more relevant than the long history of
the performance of the Dow Jones Industrial Average back to 1896, then you’re fooling
yourself, you simply are. It’s human. Again, these are all human biases, and so
it’s easy to fall for, but there’s no … The technical term is autocorrelation. There’s no correlation between what happens
on Tuesday and what happens on the following Wednesday. It might be helpful if there were, but it
doesn’t work that way. Scott Nations (28:15): There are also several biases that meld together
here and lead us to mistakes in understanding what’s likely, and recency is one. We tend to think that whatever’s happened
recently is more likely to happen again. Another one is availability. I like to think about availability. It’s that people tend to think that the
things that they are able to call to mind that are available in their memory are more
common than they are. If you’re me, you can remember the stock
market crash of 1987. You can remember what happened in 2008 and
2009. You might be able to remember the flash crash
in 2010 or the COVID crash. Most people, everybody’s heard about the
crash or 1929. A lot of people have heard about the crash,
the panic of 1907. Scott Nations (29:04): Here’s the thing, Clay. If you can remember these things that happened
more than 100 years ago in 1907, if you can remember it, it is almost certainly not normal. It is not average. We know that the way to invest successfully
is to invest for what is average, what is normal. Because if you’re always invested with the
idea that a stock market crash is just around the corner, then you’re never going to be
in the stock market. You’re never going to be invested in the
stock market, and that’s a horrible way, terrible way to try to save for retirement
or for somebody’s education. Clay Finck (29:40): Today, we hear a lot of talks on the potential
crackdown on big tech and the antitrust issues with companies like Apple and Google. I believe Mark Zuckerberg has been testifying
to Congress a couple years ago, and that put enormous pressure on their stock. To my surprise, there were also antitrust
issues with Microsoft back in 2000. What was Microsoft doing that violated the
antitrust laws, and how did that end up hurting the company and maybe even reverse some of
that big tech bubble, reverse the trend to move to the downside? Scott Nations (30:16): This is not new. This is not novel, the idea that government
can impact what’s going on in the stock market. That’s obvious, but with some of these specific
names, this is not new at all. The internet browser is really what makes
the internet available to everybody. The government said that Microsoft was using
its dominant position in operating systems to lock up the business of internet browsers,
and was making things difficult for, at the time, it was Netscape. Scott Nations (30:45): The question becomes, from the government,
as an antitrust question, “Should we break up Microsoft? Should we break up the operating system business
from the applications business? Things like Windows 97, or the Windows operating
system, should that be separated from Word, and Excel, and Internet Explorer because Microsoft
has too big of an advantage?” It looked, at one point, at the peak of the
internet bubble, that that’s exactly what was going to happen. Investors hate that kind of uncertainty. Scott Nations (31:17): The same thing happened, really, in 1929. The government decided that Standard Oil was
in violation of antitrust laws, that it was a monopoly. It probably was, and they were certainly anti-competitive. What the government decided, “Okay. We’re going to break them up,” and ultimately,
they did. That helped fuel the stock market crash of
1929. Really, the same thing happened in 1907. Teddy Roosevelt was president. He was belligerent with some of the biggest
bankers and wanted to break them up as well. This idea that government antitrust action
… I’m not weighing in on whether or not these companies were monopolies, whether they
should have been broken up. I’m not doing that. Scott Nations (31:58): I’m simply saying that markets hate that
uncertainty. I write about this in my last book, The History
of the United States in Five Crashes. Markets hate this sort of uncertainty. During the internet bubble, the dominant player
was Microsoft, and there were times when you were absolutely certain the government was
going to force Microsoft to split into two. Again, investors hate that kind of uncertainty. Clay Finck (32:21): Now, the third and final bubble you cover
in your book was the great financial crisis. Even these financial experts, these people
running these large financial institutions were falling prey to many of the biases you
outline in the book. This housing bubble was largely a result of
the belief that home values would never go down, so they structured all these products
around homes, and sold it off to investors. Clay Finck (32:47): It just was a giant house of cards that relied
on the fact that house prices could not go down. Do you think this was just due to greed and
short-term thinking by the people running these companies and institutions? Or why were these companies allowed to take
on just extraordinary levels of risk? Scott Nations (33:05): I’m not the world’s biggest fan of government
regulation, but I think what happened, Clay, is not everybody understood how much risk
they were taking, and so they were overconfident. They were overconfident in some really mundane
ways and some really complicated ways. As you pointed out, they were overconfident
about the fact that housing prices would not all, in unison across the entire country … There
had been times in the ’80s in Texas where energy prices imploded and housing prices
might have fallen in Texas, and we saw the same thing in California occasionally, but
across the entire country, housing prices had not fallen in tandem, and so a lot of
people were overconfident about that. Scott Nations (33:44): Some of the people who were overconfident
about housing prices were homeowners who bought one, and then they went out and bought another
one to rent it out, and some of them ended up owning a number of homes, each one bought
at higher and higher prices. Some of the other people who were overconfident
with the quants, literally physics PhDs, who were putting some of these mortgage-backed
securities together. They were overconfident in really complicated
ways about their understanding of the correlation of one mortgage to another. Scott Nations (34:10): It was also a lack of imagination. AIG, probably the poster child for doing dumb
things during the housing bubble, wrote a bunch of insurance to sophisticated investors
who owned these mortgage-backed securities. AIG said, “You pay us a little bit of money
each year, and we’ll guarantee you, we’ll guarantee you that your mortgage-backed security
will not lose value.” In internal documents and emails that later
became public, AIG said that their risk of loss on any of those things, on any of this
insurance was zero. The quote was, “We cannot imagine how we
would lose even a single dollar.” They ended up losing about $80 billion, but
it was overconfidence and it was a lack of imagination. Scott Nations (34:53): It was also the fact that they didn’t think
about recency. Again, what was going on right then was not
normal, and they would have been better off if they’d thought, “What’s the longer-term
trend here?” Because the long-term trend for housing is
not that it’s going to go up 20% a year, every year. Clay Finck (35:10): You talked a lot about how investors were
really overreacting during the great financial crisis, and maybe that was for good reason
that they were scared, worried, and just panicking among many people. You mentioned earlier how many investors are
aware and lived through these times, but I was only in middle school when the great financial
crisis hit, so I can really only look back and read on what happened because I did not
own any stocks during that time period. Clay Finck (35:40): I can understand how there’s just tremendous
uncertainty. You had Lehman Brothers going bankrupt, stocks
were cratering. How can we, as investors, avoid overreacting
during a crisis, and act more rationally, and believe that, eventually, the market’s
going to turn around and come back to the upside? Scott Nations (35:57): Clay, let’s think back to 2008. At the start of the year, there were five
American investment banks. There was Goldman Sachs, Morgan Stanley, Merrill
Lynch, Lehman Brothers, and Bear Stearns. In the course of just the first nine months,
two of those five failed. They went out of business. First, Bears Stearns, and then Lehman Brothers
imploded. It would be so easy when 40% of the U.S. investment
banks fail to think, “It’s impossible to overreact now. It’s going to be impossible to overreact.” After Lehman failed, the market went down
quite a bit further to the bottom. Scott Nations (36:33): When I say overreact, they sold and they never
got back in. Again, that mutual fund flow data shows that
people sold overwhelmingly in February and March of 2009, and didn’t get back in for
years. Maybe a situation like that is not the best
way to look at overreaction. That’s actually what I think is going on
here, is the edge case is probably not the best example for this. Scott Nations (36:54): Investors tend to overreact in regard to any
number of data points. Probably the best example is stock splits. The trend is clear. If a company announced that they’re going
to split their stock, that is, for everybody who has 100 shares, they’re going to give
you another 100 shares. The goal is usually, companies will say it’s
usually to bring down the price of the shares so that more people could buy them. If the number of shares is doubled, then the
price per share should be cut exactly in half. Nothing has changed. The company is exactly the same company. They’re going to make exactly the same widget
the next day. They’re going to earn the same earnings. Nothing has changed, but people overreact. Scott Nations (37:37): Investors tend to overreact to that news,
and there is a real, discernible, robust, sustainable increase in share price once that
announcement is made. There shouldn’t be. Clay, if I give you a $20 bill, you give me
two $10 bills, I don’t have any more money in my pocket than I did before, but investors
tend to overreact to that sort of thing. Scott Nations (37:59): Going back to recency and availability, we
also overreact to bad news when it comes to a stock. If somebody puts out a really disappointing
earnings report, and I’m talking about that’s a one-off, a surprising quarter that’s not
very good, investors have a tendency to overreact. There are actually a number of funds out there
that work to take advantage of your overreaction. There’s a famous one that’s run by a University
of Chicago Nobel Prize winner in economics. Again, when things are really in turmoil,
you might think, “It’s impossible to overreact,” but we tend to overreact, and then we don’t
get back in, and it hurts our long-term investment returns. Clay Finck (38:39): Your fourth and final chapter in your book,
you cover … You just wrap it all together. You take all the biases and lessons you learned
from these three crashes and bring it all together. I keep saying that this bias is so important,
and now this … but it really is true that there is so many biases that I think are important
to understand and to just be aware of. Another one is anchoring. Could you talk about what anchoring is and
how that hurts investors as well? Scott Nations (39:10): Sure. Again, the goal of telling the narratives,
the first three narratives and interweaving the discussion of the biases there is to make
learning about them, reading about them fun, as opposed to a lecture. Nobody learns very well when they’re being
lectured. Again, I hope that people will read the book,
and when I talk about a bias, they might say, “Yeah, that one’s me maybe a little bit. No, that’s not me at all. That one’s really me.” I talk specifically about 15 biases in the
book, and I hope everybody will come away and say, “These are the two or three that
I personally need to be really careful about.” Scott Nations (39:43): One of them, an interesting one is anchoring. It’s the tendency that humans have to give
too much weight to some particular data point. As an example, the price you paid for a stock
becomes an anchor in most people’s minds, even though once you own the stock, the price
you paid, other than for taxes, is almost completely irrelevant, in a few months after
you’ve bought the stock, again, other than for tax purposes, is completely irrelevant. Scott Nations (40:14): The way I describe it in the book is, let’s
say you’re looking at a house and you like that house. I tell you the asking price for the house
is $600,000. What’s the first thing you’re going to
do? A lot of people will say, “Well, I’m going
to offer 5% less than that.” Or, “I’m going to offer 10% less than
that. I’m going to offer $540,000.” I guess, my question I ask in the book is,
“Who thinks that the $600,000 number is relevant?” It may be completely irrelevant. Scott Nations (40:41): I think the first thing you ought to do is
ignore the $600,000 number and figure out what the house is worth. Look at the comparables, what else on the
block has sold for. Do that kind of math. If you heard $600,000 and you thought of some
number in your head that you would offer for that house, that is anchoring. If you bought a stock two years ago and you
paid $100 a share, and you think $100 a share is relevant now, again, other than for tax
purposes, it’s not. That is anchoring. Scott Nations (41:14): Anchoring is, again, this tendency to give
too much weight to what is, effectively, a random number, and it’s very easy to do. I talk about the trader’s prayer in the
book. Again, I stood in a trading pit for 25 years,
and so I said the trader’s prayer more than once. The trader’s prayer is, “God, just get
me back to even and I’ll get out.” Why is your entry point relevant at all? If the stock is worth X, then the stock is
worth X.” The fact that you paid 2X, or 3X, or whatever
is completely irrelevant. Scott Nations (41:49): Anchoring keeps people from making good decisions. One thing that is relevant now and that a
lot of people are probably not doing and they should is, they’re probably not harvesting
tax losses. That’s one thing that’s actionable right
now. Investors could be harvesting tax losses if
you’re trading and investing in a taxable account. You can’t sell at a loss on Tuesday and
then buy it back on Wednesday. That’s a wash sale, but there are smart
things you can do, and you should be harvesting tax losses to offset gains. Scott Nations (42:20): So many people, Clay, refuse to do that because
of this anchoring thing. “I paid $100 a share for it two years ago. It’s at 90. I’m not going to sell until it gets back
to 100.” Well, the fact that you paid $100 a share
is irrelevant. Again, the stock doesn’t know what you paid
for it, doesn’t care what you paid for it. Management doesn’t know what you paid for
the stock, and so simply hanging on to get some random number isn’t going to help. Clay Finck (42:48): It ties right in with what you were saying
earlier, how Steve Jobs does not know or care that you own Apple stock, or Elon Musk. The market doesn’t care what you paid for
the stock. If you bought Tesla stock at 1,000, just because
it’s at 600 now doesn’t mean there’s any guarantee that it’s going to get back
to 1,000 anytime soon. The market doesn’t know or care that you
own or don’t own the stock. Clay Finck (43:10): My final question for you is, we’ve studied
all these bubbles in your book, the South Sea Bubble, the tech bubble, and the great
financial crisis. It’s been said for many years that we’re
in an everything bubble driven by, in many ways, the Federal Reserve and the liquidity
they’ve added into the system. It’s led to the rise of many asset classes,
stocks, real estate, even crypto. Do you believe that this narrative of the
everything bubble is true? If so, is there anything we can really do
about it to help protect against the next big crash that might be coming? Scott Nations (43:47): Clay, listeners are going to wish we had done
this in January, since we’re now in a bear market. The S&P’s has been down more than 20% on
a closing basis. Here’s what to do, and people are going
to find this … This is not going to be the advice that people expected, I think. Here’s what to do. Invest, continue to invest. Don’t stop investing. Investing is the only thing I can think of,
the only human realm where we’re unhappy when we’re getting a discount. Well, if you have a reasonably long-term horizon,
10 years, then you would rather pay 20% less today than you did at the start of the year. Invest, continue to invest. Don’t stop investing. That’s what you can do. Scott Nations (44:37): One of my favorite biases that I talk about
in the book is called hindsight bias. It’s this tendency for people to look back
and convince themselves that what happened was so obvious in retrospect that they saw
it coming. Professor Shiller at Yale did some wonderful
research right after the crash of 1987. In an analog world, he sent out postcards
to a bunch of investors. It said, “Did you see the crash coming?” About a third of them, almost 40% of them
said yes. Scott Nations (45:07): Then he asked for their trading records. Well, it turns out that 3% of them, 3%, which
would be about the random number you would expect for a group, about 3% had actually
done something in advance of the crash. The point is that a third of the people that
he talked to were fooling themselves. Okay, we fool ourselves. Clay, what does that mean? It means that the next time, we’re overconfident
about our ability to see a crash coming, and to get out, and to front-run it, and to save
ourselves. Well, it is purely overconfidence. We have fooled ourselves through hindsight
bias. Scott Nations (45:45): Again, the secret to making money in the stock
market is to not get scared out of it, so invest, continue to invest. If you can trick yourself into thinking, “Wow,
I’m getting a 20% discount right now to where it was at the start of the year,”
then bravo. You are on your way to being a great investor. Clay Finck (46:03): Fantastic advice. I’d also add that it’s probably important
to just keep that long-term approach in mind. When you put money into stocks, keep in mind
that you should have a time horizon that’s at least a few years out, if not five or 10
years, or more. Clay Finck (46:19): Scott, I really appreciate you coming onto
the show. I really enjoyed your new book, The Anxious
Investor. I’m going to have to go back and read through
some of these biases and check in, after having this conversation, on what biases I might
be most susceptible to. Before we close out the episode, I’d like
to give you a chance to give the handoff to your work and where they can learn more about
your new book. Scott Nations (46:42): You can learn more about all of my books at
my website, that’s scottnations.com. The book is available everywhere. The only other thing I would say, Clay, is
that if somebody’s read the book and they’ve enjoyed it, one of the best ways to let other
people know that you found it useful is to rate it on Amazon, or wherever you happen
to buy it. In fact, you can rate it on Amazon even if
you bought it someplace else. Scott Nations (47:06): If you read it, and you enjoyed it, and you
think other people might find it useful, then one of the best ways to let other people know
is to rate it online. Again, they can get in touch with me, or to
read more about my books, or learn a little bit more about my crash book, at scottnations.com. You can also follow me on Twitter. Twitter handle is @scottnations. Clay Finck (47:26): Awesome. Thanks again for joining me, Scott. Scott Nations (47:28): Thanks so much, Clay. A lot of fun.
