Investing

How Investors Can Use Behavioral Finance to Win, an Interview with Daniel Crosby

Jon C. Ogg

Published: October 6, 2016 3:33 pm

Last Updated: January 13, 2020 2:42 am

When investors hear about investing and psychology in the same sentence, they might want to pay close attention. Something really good or really bad might be about to happen. So, have you heard the term behavioral finance before? As markets are looking for more ways to understand human behavior and opinion, the field of behavioral finance seems to be gathering steam.

24/7 Wall St. recently had a chance to speak with psychologist and behavioral finance expert Daniel Crosby to ask a few questions about how investors can integrate behavioral finance into their investing strategies.

Investors are told over and over that the odds are against them. They hear that the stock market is like a casino or that investing is not really any better than gambling. And they frequently hear that the machines have taken over, or that the smart money knows more than the average guy. Behavioral finance can be used by regular investors as a means of mitigating at least some of their concerns.

24/7 Wall St. chose to use the Investopedia definition of behavioral finance specific to investing, as follows:

Behavioral finance is a field of finance that proposes psychology-based theories to explain stock market anomalies such as severe rises or falls in stock price. Within behavioral finance, it is assumed the information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes.

Daniel Crosby recently wrote a book on behavioral finance called The Laws of Wealth and he is the founder of Nocturne Capital. The Laws of Wealth focuses on how the psychology of behavioral finance can help unlock the secret to successful investing.

Crosby’s view is to use timeless principles for managing your behavior and how to use those toward your own investing process. He has ten rules as the hallmarks of good investor behavior. Crosby also shows how behavioral risk can be combatted and how to take advantage of behaviorally-induced opportunities in the stock market. Clear direction is also offered for investors.

Dr. Crosby has been trained as a clinical psychologist and he applies this in his work as an asset manager. One key takeaway here — You need to follow a set of steps to manage your behavior and improve your investing process.

Crosby’s Nocturne Capital is an investment management firm with an approach rooted in the science of behavioral finance. Their strategies use proprietary research into behavioral mispricing and macro sentiment, combining conviction and value. The firm now has its proprietary Nocturne Investor Sentiment Index (NOISI). Their site says:

Our patient, contrarian approach seeks to capitalize on investor misbehavior and arbitrage emotion-driven mispricing. Nocturne’s edge is derived from a stringent process that mitigates fund manager irrationality, a high conviction approach that offers the potential for true outperformance and a proprietary tactical overlay that measures market sentiment.

24/7 Wall St. was given the chance to ask Dr. Crosby some basic questions on how behavioral finance evaluation can help investors succeed when they keep getting told that the odds are against them. We have reformatted our interview in a Q&A format here.

How could understanding behavioral finance have helped investors during the recession?

DC: To be honest, it wouldn’t have helped much in isolation. It is an unfortunate reality that knowledge and behavior have only a weak correlation, which explains why 1 in 5 Americans smoke when roughly 5 in 5 Americans know that it is a horrible decision. I buy a Cinnabon in airports not because I lack awareness of its nutritional content, but because it provides me short-term relief from the stresses of business travel.

Likewise, investors make poor investment decisions in the moment, not because they lack an awareness of the fundamentals of good investing, but because it feels like the thing to do at the time. Unfortunately, with both Cinnabon and fearful selling, the long-term results are pretty grim. Education is an important first step, but even more important is to work with an impartial guide who can keep you from making a handful of catastrophically bad financial decisions over an investment lifetime.

Why is it that when stocks get beaten up that investors want out, but at all-time highs they think they should then get in?

DC: The tendency to project the present into the future indefinitely is the undoing of most investors. During boom times, investors project that the positivity will persist unabated and the exact opposite happens during tough times. In a very literal sense, stock prices are an expression of perceived value and tend to be self-reinforcing. Cheap stocks are seen to be of low quality because of their cheapness and tend to (in the short-term) get cheaper as a consequence. As a result of this, tomorrow-looks-like-today mindset, we see momentum effects and the deeply entrenched tendency of investors to buy high and sell low.

With stocks at all-time highs and bond yields so close to all-time lows, what is the number one thing that the investing public should use to learn from behavioral finance?

DC: There is a story of a king who sends his wise men out to find the one phrase that will be true at all times, good and bad. As the legend goes, the phrase they return with is, “This too shall pass away.” If behavioral finance has taught us anything it is that excess is never permanent. I believe that medium term returns for the US stock market will be abysmal, simply because they have been good enough over the past few years to land us at a place today where we are out of sync with longer term valuations.

At my firm, we have an indicator that expresses broad market valuations as a percentile rank relative to history and we currently sit in the mid-80th percentile for the S&P 500. History says that over the next 5 to 7 years, returns are likely to be crummy as a result. Luckily, emerging markets and parts of Europe are more attractively valued, so the truly diversified investor has less to fear. Unfortunately, behavioral finance has also shone a light on the futility of forecasting and the difficulty of timing the market. So, we can say with some certainty that the US market doesn’t have much to offer over the next few years but could suggest just as forcefully that most folks’ efforts at timing the market will only make things worse.

How does behavioral finance change the public’s actions if they have a financial advisor versus those who do not?

DC: The investing public greatly misunderstands the highest and best use of a financial advisor. A recent Natixis study found that 83% of financial advisors see some of their greatest value coming from behavioral coaching and hand holding during times of market volatility. When they asked the clients of these same advisors, however, a different picture materialized. A scant 6% of the clients surveyed thought that behavioral coaching was a big value add. Studies by Vanguard, Morningstar and Aon Hewitt all put the value of working with a financial advisor at 2 to 3% per year, and the bulk of that added value comes from improved decision-making and behavioral coaching. Most financial advisors are no better than the average retail investor at picking stocks, but they can add a great deal of “behavioral alpha” by managing emotions and constraining the worst of investor behavior.

Are there some great behavioral finance lessons you could share outside of investing that might make a difference in everyone’s life?

DC: Behavioral finance can teach us a great deal about how to spend money to maximize happiness and also touches on the limits of the money’s ability to improve our happiness. A Princeton study found that making little money did not cause sadness in and of itself but it did tend to heighten and exacerbate existing worries. For instance, among people who were divorced, 51% of those who made less than $1,000/month reported having felt sad or stressed the previous day, whereas that number fell to 24% among those earning more than $3,000/month. Having more money seems to provide those undergoing adversity with greater security and resources for dealing with their troubles. However, the researchers found that this effect (mitigating the impact of difficulty) disappears altogether at $75,000.

For those making more than $75,000 individual differences have much more to do with happiness than does money. While the study does not make any specific inferences as to why $75,000 is the magic number, I’d like to take a stab at it. For most families making $75,000/year, they have enough to live in a safe home, attend quality schools and have appropriate leisure time. Once these basic needs are met, quality of life has less to do with buying happiness and more to do with individual attitudes. After all, someone who makes $750,000 can buy a faster car than someone who makes $75,000, but their ability to get from point A to point B is not substantially improved. It would seem that once we have our basic financial needs met, the rest is up to us.

The Laws of Wealth began selling over the summer and is available at major bookstores and online (Amazon and Barnes & Noble, etc.).