The Stock Market Doesn't Care How Hard You Try

hey it's Barry Ritholtz I'm here with Michael batt Nick our guest this week is Morgan Housel and we're gonna discuss the three biggest mistakes investors make welcome to the compound [Music] Morgan thanks for coming in thanks for having me so you write a lot about behavioral finance and economics as to you as do I Mike occasionally does scam space to scam right well according to gene fama the whole thing fraud so I wanted to ask you a question what do you think are some of the biggest mistakes investors make from a behavioral perspective we could sit here all day and talk about the dozens of ones but a few that stick out to me one that I think is maybe like the grandfather of behavioral mistakes is the idea in investing that results are gonna be correlated with effort and it's a really innocent mistake because investing that is I think one of the only endeavors where the correlation between effort and results is not that is not that strong but almost everywhere else in life if you want to do better at something you put in more effort like we know in investing if you can just dollar cost average and leave it alone you'll probably do if good if not great if not like a top quartile but imagine like what other industry is like that but can you imagine telling a football player if you want to get better just sit it just sit on the couch don't do anything you are describing every doctor I've ever spoken to who wants to transfer their intelligence and hard work into investing and it just doesn't work and it's and this is why it's so pervasive is because it's a really innocent mistake because like I said every other area of life that is the case the harder you try the more effort you put in the better you're gonna get like I brought the example of like Tiger Woods stories of Tiger Woods when he was like a teenager going to the range and hitting a thousand golf balls or Michael Jordan would go to the would go to the practice court and just dribble for like ten hours without ever shooting I just read that a Robert De Niro watched the Godfather 50 times before the second one seriously just over and over again yeah is that true seriously yeah you might have taken a break I think there's no there's nothing else in life where to do better you should just stop trying but there's a lot of evidence that investing that's the case and I'm not militant and passive but even to the people who are successful at adding alpha over time are they it's by and large people that are know the limits of their effort putting put into it and they're seeking alpha in ways that are super simple they're like go back to like buffets you know buffa can make a decision about an investment in an hour or two part of that is just because he's been doing this so long that I think his heuristics of getting to the right answer are so clean but I think part of it too is she's just focusing on a half-dozen variables and the super deep complex analysis just isn't necessary so even even in that situation of like successful out performance it's knowing the limits of putting your effort in and I've thought about how many years ago I read that Bill Ackman when he was doing his research on Herbalife Herbalife spent 25 million dollars on diligence which even for Bill Bill Ackman that is a lot of money 25 million dollars to do research on one company and I thought like how is it even possible at that point to be unbiased about it or do you think you've put in so much effort into this that you have to be right it's worse than that and I wasn't gonna bring the endowment effect as one of my biases but since you brought this up there is a little amount of information it takes for you to become knowledgeable about a company everything else that you're learning all it does is you're sharing information that's already publicly available and known and therefore already reflected in the stock price but what it does is it it adds to your level of overconfidence you think you really know the stock plus you put so much time and effort into it wholly it's very hard to just wipe your hands what are the hard way so you'll be endowment effect and you have the sunk cost fallacy all wrapped up in this little hey people think that effort and performance are correlates what are the odds that Bill Ackman or any of us after spending 25 million dollars would say yeah there's nothing here away you're either longer Shore zero so you talked about the grandfather what's the second cousin once removed of behavioral mistakes I think if you wrap up timing into a couple components one is just under estimating the amount of time that's probably necessary to put like the odds of success in your favor not the guarantee but the odds of success I mean even on the pounding or just letting things work out just just letting things work out an example is like most investors if you ask them will claim to be long-term investors I think the overwhelming majority people will say I'm a long-term investor and nobody short-term very few some well but a minority but then if you have the only professor professional say their short-term that's right that's true right but then if you ask people who claimed to be long-term investors what does long-term mean what is a definition of what your average holding period or what timeframe are you thinking about a lot of people will actually tell you one year yeah oh really or even here's an example is that the Fed has a survey where they put out expectations for long-term inflation expectations their definition of long-term is three years so I think that's a pretty common thing or if socially if you're heading into retirement like five years or ten years is definitely the long term but if you look historically like what is the holding period in which historically every holding period finishes with a positive return what do you mean by that if you go if you look historically on every rolling period what is the amount of time that's necessary in which every rolling period finishes with a positive turn how does that include dividends reinvested and inflation inflation and inflation adjusted and look that's rare that happened I think no I think it was actually in the in the 70s in that that stretch of terrible returns but it's happened and periods where you've gone ten years or more with either negative or crappy so let me push back you think that that's a mistake like is it realistic that somebody has an 18-year holding period no what would say that's a perfect segue into like the other part of timing is just not is the implicit expectation that like the market knows and cares about your specific time horizon right like it's relevant so you can tell people like look to do well in the stock market you need 20 years and that person who might say well great I'm retiring in four I'll give your Saracen oh no one cares about what your timer and the market does not care how much time you specifically need and I think it's like no one actually thinks like the market owes you something but they implicitly think I'm gonna retire in five years so these are the returns that I need to occur in the next five years but mark is gonna do whatever it's gonna do without it doesn't doesn't care it and anything about you everything a lot of smart people I've fallen for this myself of like okay so I'm saving in a 529 for my kids my kids are gonna go to school in 16 years so these are the returns that I'd like to earn between up and right there you're falling for a trap of like this is I'm personalizing my goals with whatever I think the markets going to do I think that just if you really wrap your head around that the markets going to do whatever it wants to do and does not give a about you then I think it just it necessitates a longer hold period than most people think really interesting Mike what are you looking at in terms of big behavioral mistakes from the man who wrote the biggest mistakes by the best investors I'll plug your book thank you thank you for the plug all right so I've got I've got a few and I think these are not necessarily like the biggest mistakes that cost the most amount of pain but I would just say maybe like some of the most common mistakes so Jason Zweig wrote about this that people often long in the wrong lessons and specifically they learn lessons that are over precise so in the dot-com bubble they didn't learn not to date trade they learned not to date rate internet stocks and then they went on to currency what else yeah yeah I think in terms of risk people either take way too much or not enough not enough is a huge problem amongst people who have substantial assets but aren't multi gazillionaires and they need to see actual compounding over decades so the dal bar study that we all know has its issues shows that the behavior gap is you know massively wide and I think that mid that might be over say but I think that the overall like portfolio cap is just a behavior gap is it's not maybe it's not dowel bars number but it's big but I'm saying it's understated because that only accounts for the money that's actually invested if you who'd the amount of people having a - they're under performing even bonds by a drastic amount because people just risk-averse but can I bring up a counter to this that was that one of my others is I think another big mistake that people make is the assumption that there's one right answer to most investing questions like is this stock cheap yes or no or is this allocation proper yes or no and I think the fly and that is that the right answer is is whatever works for you personally so I have I've written about this I have a higher cash allocation than I think any financial adviser or any model would say is reasonable what is your cash allocation so my cash any cash waiting to make a down payment it's numb where it's right for a fat my cash allocated I have four times as much stock as cash that make sense so your 20% cash and the reason is get has you need to finish no the reason is because it helps me sleep at night I'm fully aware of the returns that I'm giving up and I know what it's gonna cost me over the long-run I know that my stocks are gonna run a much higher return than the cash but I'm but I want to optimize for just going to bed at night and looking at my wife and kids and saying we're gonna no matter what or almost anything that could hit us reasonably say this will be okay we say this to people all the time the optimal portfolio isn't the one with the highest returns it's the one that you can live with yes if you have a fantastic portfolio but it makes you so nauseous that in March oh nine you sell everything and we've gotten emails from people hey I got out when you guys were very negative in owain oh nine and here it is five ten years later I'm still sitting in cash you can't recover from that yeah so you have to be able to live with it and also in terms of there not being one right answer I would not recommend my allocation to most people of my age and income it's it works for me but it might not work for you but I think the assumption that there should be one right answer causes a lot of debates and finance that aren't actually debates like we're not saying are you right or wrong people are just saying well this works for me but this works for me and it's fine if there's distance between us half of the battle on Twitter or between people who are investors and people who are traders and they argue about different things it's wildly different targets goals risk tolerances and timelines yeah of course there's a lot of one other thing that I had down was that I think that I don't know anybody that's necessary immune to this is people often think that the recent past or that the future will look like there was in past classic recency effect yeah this is something I've been accused for and I think it's a decent criticism is looking at long term history and using it is at least a proxy for what's likely gonna happen in the next 50 years and if you know anything about history you know Germany was a really civilized good society in in the in the generations before World War One World War two and then you know it's there's a long history of countries wiping themselves out and the last fifty or even a hundred years that we've had in the United States is no guarantee of what's likely gonna happen I think it's a good proxy and it's a good first approximation of what's likely to happen but the the assumption that even the long term history is a good predictor of the future when we look at the long term history of things like valuations there are some pretty reasonable arguments to make why buying a software company in 2019 shouldn't pay the same multiple when you were buying a steel company a hundred years ago with the cost of labor and the cost of capital goods and setting up physical factories now it's too literally two guys a laptop and Amazon Amazon Web Services and that's the next billion-dollar company so maybe a higher PE and I don't want to justify expensive stocks but maybe on higher that was in 1898 go back a century there's a reason why the average p/e has crept up last century and this is a point that the pseudo anonymous blogger Jesse Livermore has made that there's kind of like a pooh-poohing of recency bias that people are only concerned with what happened in the last couple years without an appreciation of history but there is a point like there's a balance between the two that if you really want to look for things in the data that are likely to be relevant to the future the recent past is more relevant and than the long past and there's things of like the long path of history that are always going to be the case these things they're just embedded in human nature but if we're looking at specific things like p/e ratios or profit margins the recent past is going to be more relevant to the future than anything that happened you know in 1872 the only thing I can tell you this is a guy named Wyckoff who wrote a book in I want to say 1923 how I trade stocks and bonds and if you just substitute internet for railroad and semiconductors for telegraph nothing else has to be changed you know it's unbeliev one of the reasons why I guess farmers cranky about behavioral finance and I am sympathetic with that view it to a certain extent is that it's very diagnostic but there's no prescription offered yeah all right yes you make mistakes so so what like so now what what do we do i prescribe yeah I would say the biggest prescription is just knowing yourself and embracing it with both hands I know that my risk tolerance is lower than most traditional models would put out so rather than saying you know trying to change my behavior or trying to look at more data to get me more optimistic I'm just gonna embrace that this is who I am and you're this man you have the ability to do so but I think that's the prescription is knowing yourself and embracing it but how is the average investor supposed to know themselves well through the help of an advisor hopefully so there's that but there's also we know people tend to be overly optimistic about their skills the the whole move towards towards indexing and moving away from active towards low-cost passive effectively admitting not only can't you pick stocks but I'm so bad at the process of managing that I'm just gonna throw it into an index and forget about it that is purely a behavioral decision-making I guess my my thing is that I'm pessimistic on the idea that humans will no longer be human no I thought it's always going to be the case particularly in aggregate there's always gonna be one making the same mistakes but if there's if there is a way that an individual can get better and I'm not that optimistic about this because very difficult it's just looking at how you've behaved in the past and realizing that that is a very good proxy for how you're likely gonna behave in the future that you're probably not going to fix your mistakes then if you panicked in 99 or if you were greedy in 99 and you panicked in 2008 you're probably gonna do that again in the future and just embrace that well and also people have different objective different definitions of mistakes one person's mistake if you think that you're gonna buy and hold one person's mistake of selling and another person's mistake is not selling if they're if they're like actively trading they held on too long and they didn't sell it early enough I'm sure there are a lot of people right now who sold in 2008 who even today would say so why so glad I did that got out you know got out they just you could make up a narrative and why something worked out well that's the classic hindsight bias where people claim to have seen things coming that they didn't see although all the choices that are obvious in hindsight we have a tendency to internalize and suddenly how many people really saw the financial crisis coming you counted on one hand and now you go back ten years later and ask people what did you see coming in oh six oh seven a half the people are gonna say well I knew derivatives were a problem I knew housing was overvalued I know I knew the subprime was a disaster that's just classic hindsight bias and I think like beyond hindsight bias the number of people who saw the financial crisis coming at all is small the number of people who saw it coming and got it right for the right reason is even smaller and the number of people who saw coming for the right reason and knew and knew what the subsequent outcome was going to be like how to play the financial crisis I think that rounds to zero or pretty close to it pretty close you had John Paulson but no no no that's a perfect example Paulson's returns after the financial crash with her end Asst right so he saw it coming for the right reason well is that a felony his his but never what to do with it which was just as important how to express that a trade so if you look at Paulson's aggregate return over a longer period of time people just focus on how much money made in oh seven oh eight he's a net money loser across this yes now it's also a yes on a dollar weighted base he was twenty billion actually at the peak no 45 versus billion through the crisis so he made two or three billion dollars then he scaled up to forty eight billion and proceeded to lose I don't know a thirty forty percent of it not only that but he was a year or two early and betting it on the housing market which is totally understandable that's my criticism but he was having to pay money out on those contracts right so I look at the net returns of that from the two years he was early on the contracts and then he made a huge gain and then he played it terribly afterwards the net return is not nearly as impressive that is but isn't that the story of all like most successful yes sir yes but that's that's the whole point of like of what hindsight bias does and putting an effort into into into your out performance this is just like a very difficult thing and even the people who we lionize if you really look at the full track record of what they've done it's usually less impressive this is true for Buffett as well in the last fifteen years a really or 1950s of ten twenty or twenty-five years and what's interesting about buffett is that he really became famous at the moment his returns started to stink right like he was back in the 70s and 80s when he was just crushing it he was still a relative nobody ran even in the 90s he was well known among professional investors but it wasn't until the mid 2000s that every guy in the street knows who warren buffett is and what he's done and that was a period in which he hasn't really liked when was the last time the buffett consistently bought companies or pick stocks that generated outperformance against Benjamin Ryan has been nothing 25 no I think it's been 25 years no during he bought goldman sachs he did a bunch of stuff it was did not leave gobbling up companies and generating alpha it's been a while it's been a long time and of course his overall track record is still great because he did so well back then so you're saying buffett should have bought into the next fund what about Bill Miller he beats the SP for 15 years in a row yeah ending in Oh a toe 9 goes from top 1% to bottom the other slash out this year he's done our mess up 70 percent I think the best-performing edge fund in the world I don't know if this is exactly right but I think like the last five years have been incredible yeah he had a great period where he famous and he had a washout where people wrote him off and now he's doing great again amazing but that gets to another point of like the consistency of performance Lee does not exist for anyone anywhere except for Renaissance Technologies maybe the lone exception but even the great investors there's a study put out a couple years ago I forget who did it Vanguard did this it was like over a 40-year period this these funds have done very well not just for a slim period their 40-year track record is great and even those funds underperformed like half the time and then who's gonna stick with it you figure these guys are tellin we're out so there was a 20 year study and 14% outperformed and of those 14% 72% underperform for three straight years yes and that's doesn't one you have a washout right nobody stick with three straight years know the performance now and you also I don't so don't think you can blame investors for walking away after a three-year dud because investors that you you can claim they're being short-term like you're oh you're just wandering away at the bottom selling at the bottom the behavior gap the worst time but if you are an investor putting your money with a professional manager what you're trying to do is size up that manager and see whether they have the requisite skills to outperform the market and a three-year it's very difficult in real time without hindsight to know whether a three-year out performance signifies that that manager has lost its skill or they're just going through a rough patch it's so easy to point fingers and other people and look at their mistakes but I think Jason said Jason's why I said like it's pay for finance is really moral value of a mirror instead of a window into a behavior like it's so easy to point to be like that person's in a today should have done that but like we're all guilty of making these mistakes I think that's like the biggest point or like another point to that I've written articles before that I thought made a made a good point I thought they were good and someone else would point out say Maureen you wrote this article a year ago that argues the exact opposite thing and I thought that article was made a decent point as well so I think like the contradictory nature of a lot of this stuff to just makes it a really difficult problem I I think that's a good place to leave it thank you so much Morgan for coming on let us know some of your most common mistakes in the comment section below thank you so much for watching and we'll see you next time you [Music]

Channel: The Compound

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Keywords: Stocks, Stock Market, Make Money, Wealth, How To Invest, Investing, Money, Trading, Retirement Investing, Financial Advice, Investment Advisor, Michael Batnick, ritholtz wealth management, finance, financial markets, retirement, saving for retirement, wall street, the compound, financial services, investment management, investment, barry ritholtz, morgan housel, collaborative fund, investment mistakes, investing mistakes, be a better investor, behavioral finance

Id: A-IWaFVAHE8

Length: 19min 56sec (1196 seconds)

Published: Mon Dec 02 2019