Afford Anything - Feeling Anxious About Your Investments?, with Scott Nations

Episode Date: June 29, 2022

#388: Recessions are terrifying. Market crashes often bring out the worst in people’s anxieties and fears. This fear triggers us to act even more irrationally than usual – which can lead to making expensive mistakes in our investment portfolios. In today’s episode, Scott Nations, who spent his career studying market volatility, describes some of the most common cognitive biases and irrational behaviors that investors make. He shares tips on how to master the mental game of investing, especially in turbulent times. For more information, visit the show notes at https://affordanything.com/episode388 Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything, but not everything. Every choice that you make is a trade-off against something else, and that doesn't just apply to your money. That applies to your time, your focus, your energy, your attention. This applies to every limited resource that you need to manage, saying yes to something implicitly means that you're accepting the trade-offs. And that opens up two questions. First, what matters most?

Not what does society say ought to matter most, but what is a genuine priority in your life, even if it's weird? That's the first question. And the second question is, how do you then align your decision making to reflect your priorities? Because oftentimes it's easy to say that we value X, Y, or Z, but actually make choices that don't line up with our purported values. So how do we do that?

Answering those two questions is a lifetime practice. And that's what this podcast is here to explore. My name is Paula Pan. I'm the host of the Afford Anything podcast. And as we all know, our fears, our anxieties, our cognitive biases, these can mess up our decision making. And when it comes to how we manage our investment portfolios, our unregulated emotions or our unchecked cognitive biases can lead to some really darn expensive.

mistakes, and that's what we're going to talk about today. Today's guest is Scott Nations, an author who has spent his career specializing in the analysis of market volatility, which is a very relevant topic right now. He's a regular contributor to CNBC, where he discusses the market and other investment topics, and his books include a history of the United States in five crashes, which is a particularly apt topic. at the moment as we are suffering a bare market. He also wrote what I'm sure is a page turner called Options Math for Traders, as well as another page turner called The Complete Book of Option Spreads and Combinations.

Most recently, he published The Anxious Investor, a book about the cognitive biases that we experience as investors. How do we recognize these? How do we manage these? and how do we master the mental game of investing? That's what we're going to discuss in today's episode. Before we get started, a reminder, Thursday, June 30, at midnight,

is your deadline for enrolling in our real estate investing course, your first rental property. After Thursday, June 30, at midnight, midnight Pacific time, We close our doors and those doors will remain shut for the rest of the year. So if you want to get in in 2022, your deadline is Thursday, June 30, at midnight Pacific time. To learn all about the course, go to afford anything.com slash enroll. We have a ton of information.

Again, that's afford anything.com slash enroll. All right, with that said, let's talk to Scott Nations about how to master the mental game of investing. Hi, Scott. Hi, Paula. How are you? I'm doing really well. Thanks for having me on.

Absolutely. Thank you for coming on. Scott, can you please tell us about your background? Sure. I live in Chicago and I have since 1986. And for about 25 years, I was a professional option trader on the floor of the Chicago exchanges. So, Paula, if you've seen the footage of the crazy people jumping up and down on the

trading floors, that was me. I had a bright red polyester jacket, would be jumping up and down for about six hours a day, trading options again professionally. And I did that for about 25 years, and now I run Nations Indexes, which is a financial engineering firm. But in the process of all this, I got to see an experience firsthand some of how, when it comes to finance, we're not always 100% our better self or our best self. Let's talk about some famous case studies throughout history in which people who have been renowned as solid investors and who have been in positions of great opportunity have fallen prey to behavioral biases that have significantly harmed their investments. Let's start with that story of the South Sea Company.

This is climbing several centuries back and a man by the name of Isaac James. Can you tell us about him? Yeah, this is really one of the first stock market bubbles that we experienced. And it happened in 1720. The South Sea Company, despite its fanciful name, had a really mundane and boring mandate. It would collect interest payments from the British Crown and distribute them to its shareholders. And it would keep a little bit for itself. So it was profitable, but really boring.

And in order to get more people into this kind of syndicate, the British government gave the South Sea Company the sole right to conduct trade between Britain and South America. Unfortunately, there wasn't a whole lot there. There wasn't much there there. And so that really never paid off. But people kind of trick themselves starting early in 1720 that this might somehow become very, very valuable, that this franchise might become very, very valuable. And so they got carried away.

The price rallied, it rallied a little bit more. And one of the first things that we saw was one of the biases I talk about, and that's herding. That is, when we're confused, when humans are confused, they tend to move as a herd. And Paula, what really happens is we're confused, so we look around, we see somebody else doing something. We think to ourselves, well, I don't know what to do, but that person must. And so I'm just going to do whatever they do.

And when it comes to the South Sea bubble, they looked around, they like, well, I don't really understand what the company is worth. They had this franchise that might be valuable, but it doesn't seem like it's valuable yet. But this person really seems to have it figured out. So let me pile in along with them. And the share price went from about 120 pounds each to 900 pounds each in the span of a few months. That's just one example of where when humans are confused, they just look around in. do what everybody else is doing. Unfortunately, that happened in 1999 with the internet bubble. It happened with housing in 2000 and well, the early 2000s. It's happened repeatedly. And it's just one of

those things that we have to learn about ourselves. And that is when we're confused, we look around to see what other people are doing. And so hurting behavior can sometimes explain or partially explained why a given stock or a given asset might rise in this speculative bubble. And it rises all out of relation to its fundamental value. And not that long ago, we saw some of this happen with what we're now calling meme stocks, for example, GameStop. A lot of people thought that it was going to go to the moon effectively. They thought it'd go to $1,000 a share. and they didn't really care what the company was fundamentally worth. They just thought the stock was going to go to $1,000 a share.

They saw their friends buying it, so they bought it. So, you know what happened in 1720? It happened last year and the year before. It continues to happen simply because it's part of who we are. And so tell us specifically the story of Isaac James, because he is one particular character who lived in the time of the South Sea Company in the early 1700s, and he bought, then sold, then bought again in a way that was rather irrational. Well, I think more than rather irrational. I think it was completely irrational.

Isaac was an old man and had invested in some of these blue chip companies. There were relatively few available at the time, but the Sousey company was one of them. And again, all it did really was pay a 6% annual dividend. And for a wealthy old person and Isaac was into his 80s, that's a perfectly reasonable sort of investment. So he owned quite a few shares. And he saw the price rally substantially, went from, as I said, about 120 pounds a share to just over 300 pounds. And he thought, you know what, this is not making a whole lot of sense. Enough is enough.

He sold all of his shares. We'll talk about that bias in a second. But then he saw within the span of just a few weeks, the price. go from 350 pounds a share to about 700 pounds a share. And that's when the herding kicked in. He decided that he needed to get back in. So he took all of his liquid net worth and bought back in from between 700 pounds, 700 pounds a share to about 950 pounds a share.

He bought back in. And that was the top. And so that's where the herding had kicked in. And that is that he had, he looked around. He saw what everybody else was doing. and he just had to be part of the crowd. And Paula, this urge to be part of the crowd is really human. I mean, anybody who can think back to something dumb they did in high school simply to be part of the crowd understands it.

And Isaac did it in 1720. Unfortunately, again, he paid the absolute top, the absolute top. And part of the problem with herding is that if you hurt on the way up, then you're really limited to what you see other people doing on the way back down. And if you don't see other people selling at the top, then you're just kind of a long for the ride. And sure enough, he bought between $700,9.50 a share. And he wrote it all the way back down, all the way back down to about 200 pounds of share. And it got to the point where later in life, he said that he couldn't even stand to hear the words, South Sea. And that's the sort of thing that happened, again, with the internet bubble, to some people that happened

during the housing bubble. It's not unusual. Unfortunately, it's devastating for people. But Paul, let's take one step back. Why did Isaac sell at 350 pounds a share, 300 to 350 pounds a share? Well, he probably thought he was being disciplined by refusing to be greedy. But this is another bias. It's called the disposition effect.

It's the fact that humans just, well, first of all, humans have a tendency to sell their winners and hold their losers when it comes to stocks. The danger here is we think we're being disciplined. We think we're refusing to be greedy or refusing to be impatient with our losers. And we know that that just not what's really going on. Our brain is so desperate for the swirl of chemicals, a pleasing chemicals that we get when we realize a winner, when we sell a winner for a profit, that that's really what's going on there. We're greedy for that swirl of chemicals. And there's a substantial amount of research and data that shows that when people give

into this disposition effect, it actually hurts their investment returns. What they sell, the winners they sell, continue to go up more than whatever they end up buying. And the disposition effect is really human. It's really normal. But we know that it actually hurts long-term investment returns despite the fact that we think we're being disciplined. Given the fact that the disposition effect is a psychological bias, we are behaviorally motivated to capture the gain. How do we distinguish between that psychological bias versus a rational decision to not be a bagholder or to sell when valuations seem to no longer be rational?

Paula, that's a wonderful question, but there are really two different motivations. The first is to simply book a gain, and the second is to make a change that is invest in something else because we think the first investment has gotten beyond its valuation. The two will merge to a certain degree. That's simply the way markets work. But the goal for investors might be to really just think about what their real motivation is. Is their motivation to book a profit so they can book a profit?

or do they really think that something has gotten ahead of itself? One suggestion I would make is wait for a month, wait for a month before making a decision, and during that month, examine your motivations. Because if you're truly a long-term investor, then waiting a month won't have any material impact on your long-term returns. How can a person examine their motivations when self-deceit is so easy? What a great question. We analyze our motivations in all sorts of psychological rums, you know, how much we drink,

how much we eat, who we choose to spend our time with. And I think simply the analysis, the thinking about it, the doing it gets us a long way to where we want to be. Simply asking the hard questions of ourselves is one way that we can start this work. Another example is sensation seeking. Roller coasters are fun for a lot of people, myself included. A lot of people like scary movies. Some people like illicit drugs or driving too fast.

That's all sensation seeking. When you sit down to trade, to execute a trade for your investment portfolio, why are you doing that? Just ask yourself why you're doing that. Is it because you like the sensation of actually executing a trade, which is very common? or is it because you're taking part in some sort of rigorous, reasonable investment methodology? And so I guess to answer your question is, if we sit down and think about sensation seeking, it's generally pretty easy to realize what we're really doing. Are we really just doing it because it's fun or are we doing it because we expect it to be profitable?

That's right. There's data around when Taiwan introduced a lottery program because casino. were illegal, when they introduced a lottery program, trading in the market actually declined by about 25%, the volume of trades placed. That's right. And that indicates that in Taiwan, which is generally a country that loves gambling, but as you said, where casinos are illegal, a lot of people expressed their sensation-seeking desire by trading in the stock market.

And when they were given a different alternative, a different outlet, then the amount of trading on the stock market declined by about 25%. There are other really interesting connections between trading and sensation seeking. There's been some research that shows that in certain countries, the number of speeding tickets that an investor gets is directly correlated to the amount of trading they do. So they drive too fast because they enjoy the feeling of it. They also probably trade too much because they enjoy the feeling of it. One thing that strikes me as we discuss some of these different investor biases is that there are often multiple biases that we need to be aware of that can at least on the surface sound somewhat contradictory. So we've discussed the disposition effect, which is an investor's tendency to want to. harvest their gains, that tendency being emotional rather than based on a sober analysis of

the fundamentals. But by contrast, there's also status quo bias, the tendency to let what is continue to be. Given that that as one of many examples of investor biases that seem to be in opposition to one another, how do we square the circle? Isn't it that any action that we take might be rooted in some psychological bias? It's likely the case that anything that we do is going to have some sort of psychological motivation. And you're absolutely right. Some of these biases seem to be in conflict or in tension. You know, the thing about status quo bias is we generally offer the status quo when we're confused. So when we're confused and we don't know what to do, And there's not a herd of people that we can look at to learn from.

That's generally when the status quo bias kicks in, even if it leaves us worse off. An example is when open enrollment comes with your employer's insurance program, a number of people, many people, large percentage of people, they end up doing nothing, not because there's not a better alternative, but because they're confused and they don't want to put it into work. And so that's where the difference comes in between status quo bias and say the disposition effect. With the disposition effect, we're not confused. So we go ahead and we take the action. With the status quo bias, we are confused. And so we opt for taking no action. What about the biases?

So those are examples of biases that seem to be in opposition to one another. By contrast, there are also many biases that seem to be overlapping or subtly different from one another. So one that stands out in my mind is loss aversion versus regret aversion. Can you distinguish between the two? Sure. And loss aversion is one that is a bias that, well, if you think about it, Paul, you think, well, of course I'm averse to losses. I should be averse to losses. But what loss aversion really means is when we are in a problem.

appropriately averse to loss. An example, a famous example, was that a famous economist offered some colleagues a bet. He was going to flip a coin. They could call it. If they got it right, he'd give them $200. But if they got it wrong, they had to give him $100. And many of them said, no, I'm going to, I would regret the loss more than I would enjoy the game. And that's where loss aversion is really, is really displayed.

it's the refusal to take an advantageous speculation or gamble, if you will, because we dislike losses so much more than we like gains. And in fact, there's a tremendous amount of data that says that we dislike losses about twice or two and a half times as much as we like gains. And so that's where loss aversion kicks in. People don't make smart speculations because they dislike losses so much more. And that also makes sense because as we lose money, the loss of each additional dollar hurts more. But to your question, Paula, let's compare that to regret aversion. And what that really means is not that we want to avoid regret. What it means is we will put ourselves into situations where we remove the possibility of regret at all.

And an example is the tendency for some people in a lawsuit to settle, not because they're making some sort of calculus, not engaging in calculus of potential outcomes and likelihoods and what it would cost, but simply because they're removing the possibility of regretting a decision. Because once you've made the settlement, you can never regret whatever comes next. You're done. And that's really the difference between regret aversion and loss aversion. Well, with a settlement, for example, wouldn't that be reflective of? of more of a desire for control? Because in a lawsuit, you may not necessarily want to hand

control of the decision over to a judge. Well, that would be interesting if people were doing that because, again, because of some sort of weighted average of the potential outcome and the likelihood of that outcome. That is generally not what is going on there. What's generally going on there is they want to remove the possibility. They want to extinguish the possibility that they will regret making the decision to go forward. And so it's not so much that they think they're making a smart bet. It's that they're actually paying up or paying more than they would to avoid knowing that they've made a mistake.

How does that differ from derisking? Well, generally, derisking is a situation where you're paying value for somebody else to take the risk. And that's what derivatives markets are all the time. An example is homeowners insurance. You're de-risking because you have to have it. Why? Because you can't afford the loss. Most people couldn't afford the loss of having their entire house burn down.

And so you're de-risking. That's a different situation than deciding that I don't want to know what's going to happen. I don't know what the potential outcome is. And so rather than avoid regret, I'm going to pay more than I should to get out of whatever situation. Now, regret is not risk, and I think that that's the difference. It's not that they're trying to avoid risk. They're trying to avoid this mental image, this mental feeling that they've made the wrong decision. I still don't think I follow because it seems to be that a person would be limiting the range of possible outcomes, the horizon of possible outcomes,

and paying a premium for the limitation in that range? Well, I mean, at some point, you're overpaying for the privilege of going home and not having to be faced with the potential that you've made the wrong decision. And that's where the difference comes in. It's not that you're making, again, a mathematically reasonable decision. You're overpaying simply because you want to avoid the negative feeling of regret. But we also see people do this sometimes when it comes to investing in the stock market. We know that if you have a reasonably long time frame, that the stock market is a wonderful place to build wealth.

There are some people who simply refuse, even though they have a substantially long time frame, because they cannot stand. And this goes back a little bit to loss aversion. But they cannot stand the idea of knowing that they made a decision to invest in the stock market and they lost money. We'll come back to this episode after this word from our sponsors. Fifth Third Bank's commercial payments are fast and efficient, but they're not just fast and efficient. They're also powered by the latest in payments technology, built to evolve with your business. Fifth Third Bank has the big bank muscle to handle payments for businesses of any size. But they also have the FinTech hustle that got them named one of America's most innovative companies by Fortune magazine.

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might affect a given investor simultaneously. As you just mentioned, there are many people who do to regret aversion avoid the stock market altogether. They don't want to participate in it because they don't like the idea of losing money. Yet at the same time, a previous bias that we discussed hurting behavior leads them to think that they ought to. The idea being, hey, everybody else is investing in pets.com, so I should as well. And often people feel pulled between these different biases, the FOMO on one hand, and the hurting behavior behind AMC theaters or GameStop, meme stocks on the other. Is it common for people to ping pong between different biases and how does a person pull out of it if they find themselves in the midst of that?

We are also wonderfully different as human beings. Some investors are just more susceptible to certain of the biases and other investors are susceptible to other ones of the biases. An example, and maybe the most clear-cut example, is the bias of overt confidence. Human tend to be overconfident about nearly everything that makes us human. We're overconfident in things about things over which we have almost no control. As an example, if you're asked, two college roommates, are they more likely than their roommate to have gifted children? The answer is usually yes. Are they more likely to avoid being a victim of violent crime? Again, the answer is usually yes. Are they more likely to end up a millionaire? The answer is

usually yes. That is, we are overconfident about many things, some of which, again, we have no control or little control, for example, being a victim of violent crime. But we are overconfident in all these things. And we're overconfident in our ability to invest well, to pick the right stocks, to build a diversified portfolio. And there's a bunch of research that shows that, as an example, men are more overconfident than women, and single men are more overconfident still. So the point is that all of us are susceptible to all of the biases to a certain degree. Some of us are just more susceptible to others, for example, sensation-seeking, because we all have different brain chemistry.

Some of us are less susceptible to sensation-seeking. Overconfidence is one example, disposition is another. So I guess my point is, Paula, that we don't fall prey to. to them in equal amounts, some of them are more likely to impact us based on who we are and some of our brain chemistry. Some of us are less likely to fall prey to some of the other ones. And so it's not so much that we ping pong back and forth. It's that some of them are just more prevalent when it comes to who we are and how we've been raised in the way our brain chemistry works. Is gaining financial literacy a solution to the problem of falling

prey to our investor biases, or is that a smokescreen or simply another way to deceive ourselves into believing that we are more rational than we actually are? Basic financial literacy is one of the ways, is one of the very best ways. An investor can avoid some of the biases. And one of the particular biases is information overload. When stocks are really bouncing around, when they're very volatile, when it seems like there's bad economic news every day. Investors, humans, we can start to experience information overload. And that leads to us doing a number of things, which are probably

suboptimal. One of them would be status quo bias. One of the best ways to avoid information overload in finance is to become financially literate. And we're not talking about being able to dissect a public company's balance sheet or earnings statement. We're talking about very basic tenants. For example, understanding the concept of compound interest, understanding the difference between a stock and a bond, understanding what happens to bond prices when interest rates rise or fall. Those sorts of relatively basic ways,

relatively basic things are a great way to kind of short circuit. some of the problems that come along, particularly with information overload. So the best investors are ones who are not necessarily, again, the most financially astute, but who are comfortable with all of these concepts and are able to discipline themselves a little bit. Oftentimes, when investors are impacted by information overload, you mentioned they become more susceptible to the status quo bias. They often also become more susceptible to hurting. they also, and we haven't discussed this one yet, become more susceptible to a few other biases. One is overreaction.

Another is the availability heuristic, salience bias, and recency bias. Let's talk about all of those. Let's start with overreaction. And then after that, let's distinguish between availability, salience, and recency, since all of those are subtly different as well. Sure. As humans, we tend to overreact to recent news that is, let's call it unexpected. So if a company were to announce earnings tomorrow and it was really disappointing, and we actually saw this with Netflix not that long ago, but if a company were to announce earnings that were really disappointing, that is much lower than investors as a group had expected, then we will overreact. react and sell that stock down generally much more than we should. And by we, I mean, Wall

Street or investors in general. That is, we overreact to this specific immediate information. And why do we do that? Well, again, it's because we're human and we have that bias. But what happened last quarter or last month is probably not the best barometer for what a company is going to do over the next 10 years. And if we have, say, a 10-year holding period, then overreacting now is harmful to long-term results. There's quite a bit of really interesting data that shows that if people will buy the worst performing stocks over a certain period of time and sell the best performing stocks over

that same period of time, that is generally a profitable strategy. That is, the ones that have performed worse are the ones that have been sold down the most, generally because of overreaction due to, you know, transient bad news. And so, you know, we bail out of some really interesting long-term investments. And again, it's because we think all we have is the news that just came out. And we don't pay enough attention to what happens on an average day. And so that feeds into availability a little bit. We, as humans, we tend to think that those instances which are available to memory, that is we can call to mind, are more common than they really are.

And why are things available? Well, because they're immediate and often there's something that is dramatic. One example is a commercial plane crash. We can generally remember some of those instances, even though for a long period, of time in the last decade, there were no deaths from regularly scheduled commercial airlines in the United States. Unfortunately, though, in that time, tens of thousands of people were dying in automobile accidents every year. But those are really not available to memory. And so we tend to think the things that are dramatic and available to memory are more common than they are.

And Paula, this is important to investors because it's unlikely that anybody listening was around in 1929, but we all know what happened in the stock market in 1929. We know what happened in 1987. We know what happened in 2008. We know what happened in the beginning of 2020 because those things are available to our memory. But I bet you most people don't know what the stock market does on the average day or in the average year. But over a long enough time horizon, 10 or 20 years as an investor, the average return is going to be much more important than those one-off dramatic returns. And that's really where availability comes into play. Yeah, you see this a lot with people who are even now still scared of buying real estate because 2008 still stand strong in their memory.

That's right. But we know that over time, real estate can be a wonderful investment. And then they lose track of what happens to real estate prices in the average year or the average decade. But that one period sticks out in their minds. And so they're like, no, no, no, I'm never going to invest in real estate. Or they're waiting for the next crash. But that's a horrible, that's a really horrible approach, tough way to build a retirement account or an educational savings account if you're not going to invest in the stock market. Right, exactly.

Is there a distinction between availability and salience or are those synonyms? There's a little bit of a distinction, particularly among academics. I think that they're very, very similar to the point where, you know, the distinctions are not particularly important. And I wouldn't want listeners to get caught up too much on trying to divine some sort of difference between the two. The things that are immediate and easy for us to recall, we just tend to overestimate their likelihood. And that's what's really going on there. Right. and then recency bias is related, but it has, of course, more of a recent bent to it.

Right. And that's the tendency for us to think that whatever happened recently is normal or common. And that's simply not the case. And if something happened recently in the stock market and you can still remember it, it's probably not very normal. And again, people will tend to overestimate the likelihood that something that happened recently is normal or average. And that's not necessarily the case. And in trying to pick out one day or one week or even one month of what happened in the stock market as a thesis for your entire portfolio is probably a poor approach. What were some of the common investor biases that played out during the 2008 crash?

You know, the interesting thing is that all of the biases play out in all of the bubbles and crashes. You can find examples of all of them in each of the crashes. One of the things that really played out in 2008 is loss aversion. As each dollar is lost, as we have fewer dollars, the loss of the next dollar becomes more painful. And this happened with investors in 2008 and 2009. And it got to the point where some investors, Big number of investors. In February and March of 2009, just threw in the towel.

They said to themselves, I can't take it anymore. I'm just going to sell. I just want to get out. So we saw that particularly in equity mutual funds. February and March of 2009 saw the biggest equity outflows from equity mutual funds that we had seen in decades. And that ended up being the bottom of the stock market. And so we have that fund flow data. we know that they fled, and we also know that as a group, they didn't come back until the stock market had rallied back substantially.

So loss aversion kicked in 2008 and 2009. They got to the point where they just couldn't take it anymore. They weren't willing to make a reasonable speculation, even if they had a really long time horizon, because they would feel the loss more than they might enjoy any potential gain. And there are some people whose retirement portfolios have never recovered from what happened. Which is an example of how these investor biases, if left unchecked, can be incredibly costly. Yes, none of these biases, not a single one, help long-term investing returns. You would just think that out of, say, 15 or so, one of them, just through pure happenstance, would help long-term investment returns. And none of them do.

Not a single one does. Now, that doesn't mean that somebody has to feel like they have to put on a suit of armor every time they want to invest. It just means you have to be aware of the biases and the ones that you are particularly susceptible to falling for. As an example, I know that of all the biases that I talk about, I am most likely to give into overconfidence. It's just who I am. It's how I operate. It's how my brain works. As a longtime professional trader, I learned to not give in to disposition.

That is, to not give into the tendency to sell winners and hold losers. But I do fall for overconfidence. And so when it comes time for me to make an investment decision, that's the bias I pay attention to. To the extent that a lot of trading now is done by algorithms, how much are we seeing these biases, human biases, play out in aggregate. market decisions. Well, make no mistake that the algorithms know about human biases, and they take them into account.

But the algorithms work in a very, very micro way, that is. If you're thinking about making an investment decision, an algorithm is probably going to take the other side of your trade, but it's very unlikely that an algorithm is going to hold a position for more than a few minutes or a day. So it's not that the algorithms are expressing the biases, but they're trying to take advantage of the biases, make no mistake. There are a number of professional investment firms, for example, that exist to take advantage of investor overreaction. They know that we're going to overreact to short-term news that is not particularly relevant for the long-term thesis. And there are firms out there that that's their goal.

That's their mandate. we're going to take advantage of investor overreaction. We'll return to the show in just a moment. One of the most recent examples of investor overreaction was the massive market crash, the massive but very short market crash that happened at the beginning of the pandemic in March of 2020. At the time, many people uttered those famous words in finance. This time it's different.

But that time, many people, I always, heard made a case that, you know, it truly was different. It's a pandemic. We haven't had one in a hundred years. There is no doubt in my mind that the next time we have some massive move in the market that's similar to what we experienced in March of 2020, there will be some other precipitating event that is probably unusual, probably an event that most of us never have experienced before. And again, people will be able to say, no, really, but this time it's different. what should we tell ourselves when we find that that thought creeping in? It's not different this time. It's just not. There's always a catalyst for a crash, and it often has absolutely nothing to do with finance. That was true for the panic of 1907, the quintessential crash in 1929, the one in 1987, and the flash crash in 2010. So there's always some sort of catalyst. Again, it often has nothing to do with finance, but it's never different this time. Can you go through each of those crashes and talk about what the catalyst for each one was? Like, start with 1907? Sure.

The catalyst for the panic of 1907 was the San Francisco earthquake of 1906. So all of the available capital in the country ended up heading towards San Francisco for the rebuilding. About 40% of the available capital in the country headed to San Francisco to find. fund the rebuilding. And that left the rest of our financial system really bereft of capital. The result was the panic of 1907. Further catalyst of that was that without capital, the number of banks ended up failing and the stock market crashed. In 1929, the catalyst was a fraud. A guy in London was counterfeiting stock certificates. And so everybody looked at their stock certificate in an age where paper was king and said, I don't know if this was real. I don't care about the value of the

company. I just want to make certain that I get out. In 1987, the crash at probably top of mind for a lot of people because it was by far the most, the biggest crash in a single day, the biggest loss in a single day, 22% for the Dow. People have forgotten it in the weekend before that crash. We were effectively at war with Iran. They had fired a number of missiles at a U.S. flagged tanker in the Persian Gulf and we responded militarily that Sunday. And so when you woke up on Monday, October 19, 1987, you were certain that we were at war with Iran and the stock market crashed that day. And then in the flash crash of 2010, that was precipitated by rioting arson and murder in Athens as it looked like the Eurozone was going to come undone. And so there's

always some sort of catalyst. And again, often it has nothing to do with finance policy. The danger, though, is that the time between the catalyst and the crash is collapsing. So between the 1906 earthquake in San Francisco and the subsequent crash in 1907, there was a year. In 1929, span was about a month. In 1987, it was a weekend. And in 2010, it was a day. So we've gone from a year to a month to a weekend to a day. And now, if we have some sort of catalysts, like a pandemic, given the,

the way our news cycle works, it happens very, very, very quickly. Right. It could be within hours or even minutes. If we got bad news from China, if China said we're going to go to war economically with the United States, it would probably be less than five minutes. Given those collapsed timelines, does that also mean subsequently on the flip side that the recoveries are also faster? The duration of the pain is shorter? It depends on what the response is. The Federal Reserve has now figured out what the response should be to this sort of dislocation.

The Federal Reserve didn't even exist in 1907. In fact, the Federal Reserve was created as a result of the panic of 1907. The Fed didn't understand how to react in 1929, and so the reaction was probably the opposite of what it should have been. Alan Greenspan knew in 1987 exactly what the response should be to the stock market crash. And now we have a playbook that works. So the Federal Reserve says to the world, we have money, we're going to lend it, interest rates are going to go down. And that is the sort of response that markets and investors want to hear.

And it works beautifully. So we have at this location, and as long as the governmental response or the Federal Reserve's response is appropriate or what we expect, then we tend to bounce back pretty quickly. And we certainly saw that at the start of the pandemic. We've seen that twice in the last decade. So we saw that after the 2008 Great Recession when there was heavy government intervention. And we also saw in 2020 at the beginning of the pandemic, interest rates decline, stimulus payments get made. We saw so much support that I've had a few guests on this podcast who have talked a little tongue in cheek about whether or not this is the end of recessions. But what we've also seen is, of course, the highest inflation in 40 years.

Will there or could there be a future in which the Fed fails at both ends of its dual mandate? It can neither prevent a recession nor could it keep inflation in check because creating money, flooding the system with money, in order to abate recession, lends itself to so much inflation that the whole thing just sort of runs away. It's the right question at the time. It's the right question for the time. The Federal Reserve has to know the right response. But like a parent, they have to know when to quit helping. I think that the main reason we see the inflation that we do now is because the Federal Reserve did not know when to quit helping.

The Fed responded entirely appropriately in 2008 and 2009. Two of the five American investment banks had failed. Nobody had any confidence in the economy of the stock market. There was never a day in 2008 when our stock market was actually higher for the year. Every day in 2008, it was lower than where it had ended 2007. So the Federal Reserve responded appropriately, but they also have to know when to pull it back. And I think it's clear, and history has been the judge, that they did not pull it back soon enough or appropriately. and that's also the case after the accommodation that they unleashed in 2020.

But what that means also is that if they don't respond vigorously enough up front, then they're not going to have the problem on the back end of having to pull back at the right time. So I think it's unlikely that we'll see them fail to be aggressive up front and then have to worry about pulling back sufficiently once the crisis. has passed. I just think that those two are going to be mutually exclusive. It is possible that they will overcompensate on the front end and then fail to pull it back in on the back end. And I think that's what we're experiencing now. Does that give investors a greater degree of safety? So the idea that a market crash might not ever be too bad, that the Fed will step in

or that the powers that be will step in to pull the economic levers needed in order to spare our society from ever experiencing a 1929? It certainly does not mean that we won't have another crash. What I think it means is that we will not have another period like the 1930s where our response is counterproductive in the extreme. Again, we're human. we will over-speculate. We'll have some sort of contraption that we don't quite understand very well that will inject leverage into the system at the worst possible time. Every one of the stock market crashes that we've experienced has seen some sort of financial contraption run off the rails and inject leverage at the worst possible time. And we're creating new ones all the time.

We'll have some sort of catalyst that we didn't see coming and couldn't have planned for. So crashes are uniquely human. event, and we will continue to have them. I think what this means, though, is that the sort of devastating decade-long depression like we had in the 1930s is extremely unlikely. Well, good. We will wrap it there. We're coming to the end of our time. But it is uplifting to wrap it on a note of hopefully the worst that we could reasonably anticipate experiencing might be crashes, sure, recessions, sure, but hopefully we're out of the woods when it comes to a protracted depression. The stock market is a wonderful place to build wealth and create a retirement

and to fund your children's educations. And the stock market, if you meet it halfway, the stock market will do all of the heavy lifting. So invest, keep investing, remain invested, don't pull out because of loss aversion, and you will end up doing well as long as you have a reasonably long time frame. It's almost impossible in this day and age. We're responsible for our own retirements. It's almost impossible to fund a retirement without investing in the stock market. And again, it will do all of the heavy lifting if we'll just meet it halfway.

Well, thank you so much. Where can people find you if they'd like to know more about you and your work? They can go to my website, Scottnations.com, and I write their account. occasionally, and they can also learn a little bit more about all of my books. Great. Thank you. And The Anxious Investor is your newest book. The Anxious Investor, yes, mastering the mental game of investing. It came out in April. And again, the goal is for people to read the narratives, enjoy the narratives, and see themselves in the mistakes that are made. Perfect. Well, thank you so much, Scott.

Thank you. Thank you, Scott. What are three key takeaways that we got from this conversation? Number one, investors are often led astray by a variety of irrational cognitive biases. Let's walk through a few examples. One cognitive bias is called status quo bias, and that's our tendency to overvalue our current situation, such as our current mix of assets, the assets that happen to already be inside of our portfolio. We overvalue the status quo, and we demand a higher burden of proof to justify

any change, a higher burden of proof for that change than the burden of proof justifying holding the status quo. Part of the reason for that is due to what's referred to as information overload. When we feel overwhelmed by excess information by too many choices, we react by doing nothing. The psychologist Barry Schwartz refers to this as the paradox of choice. The more choices were offered, the more likely we are to not make any decision whatsoever If we are at a farmer's market and we're trying to buy jam, and we are presented with three flavors, strawberry, cherry, or grape, it's fairly easy to make a decision. Great, which jam or jelly do you want?

Strawberry, cherry, or grape? Those are your three choices. But if we're presented with 27 flavors, we often get so overwhelmed by all of those options that we end up just not doing anything at all, not buying the jam, not making the choice. So that's an example of how information overload contributes to status quo bias. And that is one of several examples of the types of cognitive biases that lead investors astray. Another example is called the disposition effect. When we do make a change, we often make the wrong one.

The disposition effect highlights how humans have a tendency to sell their winners and hold on to their losers. So you sell the winning assets and you hold the losing assets. Why is this? Well, we get a dopamine hit when we sell a winning asset and we lock in our gains. Meanwhile, sunk cost fallacy makes us want to hang on to the losing asset, quote, until it comes back. You know, how many times have you heard somebody say that or have you yourself said that? Right? Some cost fallacy, coupled with loss aversion, makes us not want to convert paper losses into real losses, and it motivates us to convert paper gains into real games. And this is known as the disposition effect. Now, there are times when making these moves is absolutely valid, and that validity is based on fundamental analysis. But there are other times when our internal biases and our emotions, are driving that decision.

Paul, let's take one step back. Why did Isaac sell at 350 pounds a share, 300 to 350 pounds a share? Well, he probably thought he was being disciplined by refusing to be greedy. But this is another bias. It's called the disposition effect. It's the fact that humans just,

well, first of all, humans have a tendency to sell their winners and hold their losers when it comes to stocks. The danger here is we think we're being disciplined. We're refusing to be greedy or refusing to be impatient with our losers. And we know that that just not what's really going on. Our brain just is so desperate for the swirl of chemicals, a pleasing chemicals that we get when we realize a winner, when we sell a winner for a profit, that that's really what's going on there. We're greedy for that swirl of chemicals.

And there's a substantial amount of research and data that shows that when people give into this disposition effect, it actually hurts their investment returns. So if you're thinking about selling off an asset that's performing well, ask yourself, what's the true motivation behind that decision? Do you want the dopamine hit? Or do you believe that some underlying fundamental has changed? And compare this decision to your investor policy statement, which is your written statement about your goals, your timeline, your risk tolerance, your risk capacity, your strategy,

your style, about the boundary conditions and triggers. that serve as your decision-making guideposts? Is this decision aligned with your own written personal investment policies? These are some examples of and ways to manage, a few common cognitive biases. And that is the first key takeaway. Key takeaway number two, different people are susceptible to different biases.

There are many cognitive biases out there. We've just highlighted two of many. And often, when you start learning about these cognitive biases, you find that there are many that are contradictory. One bias would lead you to do X and the other would lead you to do the opposite of X. So I asked Scott, does that mean that we ping pong between

contradictory biases? And he replied that what tends to happen is that certain people, depending on your personality, your disposition, your prior life experiences, certain people are more susceptible to certain biases than others. I guess my point is,

Paula, that we don't fall prey to them in equal amounts. Some of them are more likely to impact us based on who we are and some of our brain chemistry. Some of us are less likely to fall prey to some of the other ones. And so it's not so much that we ping pong back and forth. It's that some of them are just more prevalent when it comes to who we are and how we've been raised in the way our brain chemistry works. So each person is different and the biases that you yourself might be most susceptible to are different than your spouses or your colleagues or your neighbors.

And so part of recognizing your cognitive biases comes from recognizing your own susceptibility. Scott, for example, observes that he is most susceptible to overconfidence bias. Now, that doesn't mean that somebody has to feel like they have to put on a suit of armor every time they want to invest. It just means you have to be aware of the biases and the way. ones that you are particularly susceptible to falling for. As an example, I know that of all the biases that I talk about, I am most likely to give into overconfidence. It's just who I am. It's how I operate. It's how my brain works. As a longtime professional trader, I learned to not give in to disposition. That is, to not give into the tendency to sell winners and hold losers. But I do fall for overconfidence.

And so when it comes time for me to make an investment decision, that's the bias I pay attention to. And so taking that personal inventory, knowing yourself, can help you be a better investor. That's the second key takeaway. Finally, key takeaway number three, during stressful financial periods, which by definition, market crashes are stressful, that's when you see all of the biases come into play in a very strong way. Take a look, for example, at the Great Recession of 2008, 2009, and how much biases, such as loss aversion, played into people's psychology. And it played into that investor psychology to such an extent that people made decisions that ultimately cost them, either through loss or through opportunity cost, tens of thousands, perhaps hundreds of thousands of dollars. Individual investors did this. And of course they did to do so as human because market crashes in particular are emotionally stressful, emotionally demanding events.

And that's when mastering the mental game of investing becomes particularly important. You know, the interesting thing is that all of the biases play out in all of the bubbles and crashes. You can find examples of all of them in each of the crashes. One of the things that really played out in 2008 is loss aversion. As each dollar is lost, as we have fewer dollars, the loss of the next dollar becomes more painful. And this happened with investors in 2008 and 2009. And it got to the point where some investors, a big number of investors, in February and March of 2009, just threw in the towel. They said to themselves, I can't take it anymore.

I'm just going to sell. I just want to get out. So we saw that particularly in equity mutual funds. February and March of 2009 saw the biggest equity outflows from equity mutual funds that we had seen in decades. And that ended up being the bottom of the stock market. So as we deal with the market realities of this year of 2022, we know we're in a bare market. We may or may not already be in a recession. And if we're not, we may or may not, we may or may not be heading for one. We have the highest inflation in 40 years. Across the board, assets are tanking, stocks, bonds, crypto. Basically everything other than real estate has declined as of June 29, as of the time that this episode is coming out. Interest rates are high,

gas prices are high, home values are high, everything feels expensive. Your portfolio is a fraction of what it used to be, consumer credit, i.e. credit card balances are growing at a pretty significant clip. There are whispers or concerns that there may be a growing consumer credit bubble that might be the next shoe to drop, the next thing to look out for. And it's possible that we are in for a protracted, difficult time. And in these types of economic conditions, knowledge, support, community, clear thinking, clear thinking becomes particularly important. You know, there's an expression, when the tide goes out, you see who's swimming naked. In an upmarket, it's easy to blindfold yourself, throw a dart at a list of assets, make money, and assume that you're a genius.

There's another expression in a bull market everyone thinks they're a genius. But it's times like this, it's when the chips are down, that knowledge becomes particularly important. And self-knowledge, which is the recognition of cognitive biases, the topic of today's episode, plays a major role in that. Because unless you understand yourself, your own psychology, your own susceptibility to certain biases, unless you have that understanding, then it's possible that you may think you are making the rational decision when in fact you are making a rationalized decision.

It's a fine line between the two. So biases play out in all crashes. This one is no different, but how each of us, as individuals, as households, as investors, as each of us develop the skill sets, the mental skill sets to deal with this, we become better at making money and keeping money in all economic environments. And that's the goal to be better each year than you were the year before. Your portfolio may be down, but if your skill set is up, if your thinking is more clear, if your decision-making framework is more dialed in, then you yourself are in a better position this year, even if your portfolio is down than you were the year before. And that's the goal is to always be improving. So those are three key takeaways from this.

this conversation with market volatility expert, Scott Nations. Thank you so much for tuning in. My name is Paula Pant. This is the Afford Anything podcast. If you enjoyed today's episode, please share it with a friend or a family member, a sibling, a coworker. Anyone you know who's nervous about the market right now, please share this episode with them.

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follow her. She also explores all the options and weighs their pros and cons, which gives some great insight into how to make financial decisions. Thank you so much. I'd also like to give a shout out to J.A. Murphy, who says, quote, great podcast that helps provide insight into not only how to think about your finances, but how to think about hurdles in your everyday life. Paula brings on amazing guests, and her interview style allows the listener to dive deep into their message. I also enjoy the Ask Paula episodes where she answers listener-submitted questions along with that basement podcast guy. I haven't learned anything from his podcast. That's an inside joke about Joe.

But as a guest on Afford Anything, Joe provides an interesting, contrasting opinion to Paula's, demonstrating multiple approaches to a given solution. Thank you so much, J.A. Murphy. And for people who are wondering, Joe's schick on the Stacking Benjamin's podcast is, you won't learn anything here. So that was what they're referring to. Thank you for both of those reviews. Thank you to everyone who has left us a review. We appreciate these reviews so much. And they go a long way in helping us book amazing guests that you can learn from.

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I hope you take at least one idea from today's episode and put it into practice. Thanks again for being part of this community and I will see you in the next episode.