Afford Anything - The Thinker's Guide to Market Volatility, with Dr. Steve Wendel and Sam Lamas

Episode Date: April 27, 2020

#253: Dr. Steve Wendel is a behavioral economist and the head of behavioral science at Morningstar, an independent investment research firm. Samantha Lamas is also a behavioral researcher at Morningstar. They discuss the hidden biases in our decision making and how these hidden biases affect us - particularly during this pandemic and during times of high anxiety and stress. They also discuss techniques that will help us avoid deceiving ourselves. For more information, visit the show notes at https://affordanything.com/episode253 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 applies not just to your money, but also to your time, your energy, your focus, your attention, any limited resource that you need to manage. That leads to two questions. Number one, what matters most to you? What is worth sacrificing other things for?

And number two, how do you make sure that your decisions on a day-to-day basis reflect that? Answering these two questions is a lifetime practice, And that's what this podcast is here to explore. My name is Paula Pantt. This is the Afford Anything podcast. And right now, the spring of 2020, the market is incredibly volatile. It plummeted, then it rose. Some days it'll drop 4%.

Then it'll rise. 6%, then it'll drop. 5%. Basically nobody knows what to expect. Not just in the market, but in the overall economy. And this type of volatility can lead us to start relying more on gut feelings and hunches and reacting more based out of our emotions when we make investors. decisions, particularly in times of volatility, we are more prone to acting out on our

cognitive biases. And that is the topic that today's two guests are here to discuss. Dr. Stephen Wendell is a behavioral economist and the head of behavioral science at Morningstar, an independent investment research firm. Samantha Lamas is also a behavioral researcher at Morningstar. They join us today to talk about the hidden biases in our decision making and how that affects us, particularly during this pandemic and during times of high anxiety and stress. And they also offer techniques to help us avoid deceiving ourselves. Enjoy. Hi, Sam and Steve. Hi, Paula. Hi, Paula. Thanks for having us. Thank you for being on this show. There's so much going on right now. I'm glad to have

some experts in this field who can talk about how to cope with the craziness of the world. We're happy to be here. And thankfully, behavioral science does have some lessons, which may be able to help right now. Right now, a lot of people are feeling anxiety, anxiety about their incomes, their investments, uncertainty about the future. How do people cope with this anxiety in such uncertain times? Sure. So I think there's a few things investors and people can do to really help themselves make the best decisions they can, given everything that's going on right now. So one of the things we like to recommend is one for investors to take the time to understand their own biases. So I'm not entirely sure.

Maybe I should explain biases before I talk about dealing with biases. But behavioral science, from the world of behavior science, we know that people take shortcuts when making decisions. And usually shortcuts are for the better. I mean, they help us make the 1,000 decisions we make every day. They help us make fast decisions when we need to. But there are times. when these biases can lead us astray and they lead us to the wrong conclusions. Unfortunately, our finances is one of the main areas where this seems to happen to us, where the

shortcuts we depend on for our everyday lives and our everyday decisions just don't really work out for us in the end. And given everything that's going on with the pandemic, individuals are, as you mentioned, stressed out. There's a lot of uncertainty out there. People are worried about their health, about their income, about their jobs, about their family, et cetera. I mean, investors are dealing with a lot. So this may mean that their minds are going to depend on those shortcuts a little more, and they might make more decisions or more mistakes than they would typically do under normal circumstances. So one of the first things we recommend is to read it up on the psychology behind our decisions, why our emotions and our minds and

shortcuts and can lead us astray when it comes to making big financial decisions. Can you walk us through some of the most common biases that you see? Yes. So one of the common ones, especially during the 08 crisis, was recency bias. So naturally, when we're trying to predict the future or make a decision, our mind naturally thinks about what happened most recently. So during the housing crisis, what happened most recently is usually, oh, the market is going down. So our minds think the market is going to continue to go down. And we get into problems when people make financial decisions based on

recency bias or based on what just happened. And this can lead to people thinking, hey, my portfolio will just drop 10%. It's going to continue to drop. And then usually that prompts some sort of behavioral issues like wanting to sell out during a downturn. Sometimes recency bias can appear in the form of a person. rationalizing to themselves that that decision is justified based on what they're reading in the news. So a person might be affected by recency bias, but they would rationalize it by saying, well, you know, here's factor X, factor Y, and

factor Z. How do you distinguish between countowing to your biases versus acting on information? Yeah, and that's a tough one because in the scenario you just explained, there's also little bit of confirmation bias. So naturally, our minds just pay more attention to news and facts that happen to agree with our opinion. So one of the techniques we recommend for that scenario is we challenge the person to go and find something, some sort of news article or finding that disagrees with their opinion. So it's sort of like explaining the opposite. If you want to make this cell decision, try to explain why someone would be on that other side of that transaction and want to buy. We can think more generally that, well, sure, in everyday life, we use quick shortcuts in

order to make decisions. And it's not that those decisions are always bad. They may be making some very well-informed decisions. One way to think about it is not so much how can we tell if it's recency bias or information, but how do we just stress test that decision? How do we take a step back and analyze that choice from another perspective? So explaining the opposite is. is a great one. But there are other ways also that we can take a step back and stress test that choice. One way is just, well, wait a while. Think about it a few days later. See, would you still make the same choice? Explain it to your spouse. Explain it to a friend. In that social context, do you still want to make the same choice? Because if it's a solid, thoughtful choice,

it should withstand that scrutiny. If a person has an investor policy statement that's written out that guides the way in which they make their decisions about their money management. Is this a time, you know, these times of uncertainty, these times of high anxiety, is this the appropriate time to make modifications to such a set of rules, or is this the time to adhere to it? And if any modifications are needed, defer those until we're in the clear. Well, my vote would be this is the time to stick to those pre-planned rules that you already said. out for yourself. Oh, this is a tough one. All right. I think, I think Sam, I'm going to, I'm going to slightly disagree with you. Okay. I would say that each person is different.

You may be trying to buy a house right now. You may be deciding whether to take a new job, as well as investing decisions, the wide range of decisions. Or maybe, or you may be withdrawing money in order to make a major move in your life, right, buying a house, etc. You still may need to do that. So the question is, how can we help people have the freedom to, well, make a choice, because this was the time to make a choice anyway, without just saying, okay, you have to hold off from doing anything. Because that's a particular type of paralysis that can hurt on the other side. And we often think of folks that want to make a move, sell their investments, et cetera, because of stress, but there may be lots of other reasons. They may have good rational reasons.

And so I look more instead at how can we, well, slow down and have that thoughtful decision and separate out the, okay, this is really the right time for me versus the stress. And so I would say sometimes, if I can hedge. So we've talked so far about recency bias and confirmation bias. What are some of the other common biases that you see come out, particularly during times of stress? Yeah, I think one of the ones that I realize myself sort of being prone to is, especially when the pandemic first hit and the volatility was really starting to run its course was action bias. This is our tendency to want to take action. So when we see our portfolios losing money, for example, we want to stop the bleeding.

And I think many times people seem to take the wrong action. And it's more so about being, I guess what Steve was saying earlier, being more thoughtful about your decision-making process and about what actions you're taking. For example, one of the things that helped me was reframing that bias towards action. So instead of taking action in a way of maybe starting to sell investments, even though I honestly don't have to because my goals are so far away, but trying to take the right action. And there are plenty of things investors can do right now. For example, this is a good time to rebalance.

This is a good time to increase your savings rate or even to take advantage of some of the mispricing going on in the industry right now. And how would a person do that? Buying low, selling high. So right now, everything is low. So if you're trying to be, trying to take advantage of some of this lowness, because there's a lot of investments out there that some investors or some professionals may make the claim that they are undervalued at this moment.

So buying that up and waiting until the upswing comes. So this is a question that I think a lot of people in this community have been grappling with. on one hand, we're taught don't try to time the market, dollar cost average regularly, but then on the other hand, as you just described, we are also hearing there's an opportunity to buy on the dip, which inherently is market timing. So how do you square the circle? Well, I'll tell you myself, I'm struggling right now with a kind of subtle form of overconfidence in investing. And it relates to this buying the dip. I'm a contrarian investor. I look for the fundamental value of a company. I look at the current price and I see, okay, where is there an opportunity?

And I find myself slipping into, well, hey, maybe because I'm a contrarian investor, I've got this special knowledge that the rest of the market doesn't. And maybe I can, you know, maybe I can time it. Maybe I can get it right on the bottom point of the dip and I can do great. And that is, of course, crazy. So, I mean, Morning Store puts out wonderful information on that fundamental value. I think Where we get into trouble is when we start thinking, okay, well, that means I know what's going to happen next. I know what's going to happen. Okay, well, I think this is the low point or perhaps you're in reverse. I need to wait a few more days before things drop further.

That's me trying to forecast what's going to happen in the markets. And I don't have any way of an ability to do that. But there is another way as a contrarian investor that we can treat this, which is I have no idea where the puck is going. I know where the puck went, but it's irrelevant. Instead, let me just look at where the puck is right now. What is the current price? What is the current, best of our understanding, fundamental value of a company or of a fund? And am I happy with that?

Do I have a margin of safety? Sure, maybe possibly it's going to drop further and I could get an even better bargain. But that's crazy talk. So what I've done to try and fight this because, man, I feel it all the time, is I just try and I have set, buy limit orders and say, okay, when it crosses this threshold, buy. I don't know if it's going to go much further, but all I know is at this price, I think it's a good investment. And so that's one way around this challenge of, well, buy the dip and don't market time. Well, it's buy a company that is undervalued at a given point in time and don't even try

to think about what's going to happen in the future, because none of us can predict that well. So simply buy when it's a good deal and sell when it's a good deal, but don't try to capture the highs or lows. Yeah. Indeed. At least that's what I'm trying. But I'm just as prone to confirmation bias and seeing the signals that point to how I'm just an awesome human being and ignoring the others, right? So we all have this. You talked about how we fundamentally, we have no idea what's going to happen in the future. None of us can reasonably predict where the market's going to be tomorrow or next week or next month. Yet at the same time, there are circumstances that we're aware of. So as of the time of this recording, which is April 21st, you know, we are seeing some movement in several states to start to reopen some businesses. We know that we are probably going to have two consecutive quarters of negative GDP growth.

I think it's reasonably certain to say that we're going to, in hindsight, look back and see that this was a recession. So we know those things, or at least we think we know those things. how do we apply that knowledge, or should we apply that knowledge, given that we also cannot predict the future? I think that is, yeah, absolutely we know that. The hard part is understanding that everybody else knows that too. Or that they may know something even more than we do. And some high-frequency trader has gotten that information a millisecond before I ever got it, even on my best days. And they're already acting on it. And so how do we know something and at the same time feel good about it, feel confident, and still know that it's not unique and we're not special? That's really hard. Right. So we don't have any specialized knowledge beyond what everybody else has and therefore we're not going to win the stock market. I am sure somebody actually does have special knowledge. It just ain't me. It's just a really hard thing to keep in mind. And so I write out my investing work.

rules and say, okay, at this, this is when I'm going to look. These are the thresholds I want to look at. These are the data sources I want to use just to remind myself, yeah, you know, anybody else could have written this too. What are some of your rules and your favorite data sources? Well, morningstar.com, of course. No, I mean, I personally put a great deal of confidence in the thoughtful, careful analysis of Morningstar analysts and in being unbiased because these folks have a long history of just telling the asset management firms that they're full of it and that what they're saying isn't true. And they've kept their independence and it's really impressive. And so I use the analyst ratings, absolutely. I use our forward-looking ratings as well as our price to fair value because

those are folks who know more about a particular company than I do and they have an independence and are looking at what's a fair value of this company. So honestly, I use Morningstar quite a lot and then I intentionally try and look for some outside sources as well that disagree and just and balance that out. Like Sam mentioned before, Sam, what's your, how do you, how do you attack this? Yeah, so I have, I guess I'm more of a laid back investor than what Steve described, only because I'm, it may be my age, but I depend more on robot advice. So, I have a great robot advisor for a retirement account that I frequently use for any sort of investment decisions. But what I really try to do in my finances, especially when all this market volatility is going on, is remember what my goals are. So I think a lot of the times when we're worried about these day-to-day price changes,

what we really have to do is take a step back and remember that what the price is when we take a certain amount of money out of our investment is, is not really the goal. Returns itself is not really the goal. The goal is really to buy a house or to retire when you're 65 or to relocate when you do retire. So whenever I try to make a decision or whenever I feel panicked, it's really about me just going back to what my goals are, remembering that I have plenty of time to retire. Or, for example, I was already very well positioned to reach a certain goal. That's only five years out, etc.

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Black Friday deals for up to 70% off. That's W. W. W. W. W. F-A-I-R-com. Sale ends December 7th. How much cash should a person be holding it this time? Well, I don't advocate that they change that position. Again, it's just so hard to make any blanket statements about investors. Now, I'm a contrary investor, so I thought that the market was overvalued before. And so I have some cash available.

And I'm following the rules that we recommend to others, and then I'm doing myself. Set a set of threshold, set a set of rules. but how much cash people have on a hand? That's suddenly it's one of those things that we always wish we were in a better place and that knowledge does us almost no good because you have to have done that before everything happened. So, I mean, we've got what we've got. So how do we, as Sam mentioned, focus on our goals and focus on whether we're okay or not. So maybe I had saved up and I had some investments for a house in a few years, right?

And now slowly derisking that as the house purchase arrived, as the house purchase neared. well, okay, sure, maybe my investments, let's say it's more stock-heavy, maybe my investments have dropped. Well, okay, maybe house prices have two, or maybe there's certain areas that I could go to where things balance out. And instead of focusing just on this one part that's negative, look at the broader picture of my goals and say, yeah, okay, I might be all right. You know, I might have wanted to live in San Francisco, and there was absolutely no way I could afford a house. But, okay, maybe things might change a bit. and somebody who has to sell, I can be a buyer to provide that liquidity and help meet my dreams as well. Let's go back to this conversation about biases.

We've talked about recency bias, confirmation bias, and action bias. Tell me about some of the other common biases that tend to afflict people, particularly in times of anxiety or times of uncertainty. I think another popular one is hurting behavior. So when we're not exactly sure what to do technically or usually on an everyday basis, we look to the crowd and we follow the crowd. And this works out very well for us in everyday life. When it comes to our finances, especially when there is volatility and investor panic, usually the crowd is going in the wrong direction. So when this whole pandemic really hit, a lot of things I was hearing from my friends and family is, oh, everyone's selling out. Should I be doing that?

And that's hurting behavior pretty much to the T. So once again, when people are facing hurdy behavior, what we like to do is remind them to go back to those decisions that they made early on. So the rules that they prepped early on that Steve already mentioned or helping them reconnect with their goals when everyone else is running for the hills. What should a couple do if one spouse wants to follow the crowd or one spouse has a set of ideas about, how to handle their finances at a time like this, but the other spouse disagrees. Oh, yeah. That's a tough one, because who are we to intervene in the stresses of a family? Thankfully, there is some research that might be able to help those couples.

There's research on how couples interact with each other and how so often that financial disagreements can be one of leading causes of divorce and stress. and difficulty within a marriage. And so while there are no blanket prescriptions, we look at what tools are available, how can people help? Now, as it happens, Dr. Serenukum on our team, has a new tool called Money Talk, which is specifically for this problem,

for helping couples talk about their finances and understand some of the emotions that might be at play and just try and get on the same page. She has an article on Morningstar.com that will be posted shortly, actually come out right after this podcast, and we're making the tool itself available for free on Morningstar.com for people to try

because we know so many people are struggling with this. Now, someone kind of stepping away from the really difficult conversations, where it isn't a tremendous stress on a marriage, right? When we just, there's a disagreement, one can also see that as a potential opportunity as a way to, well, to test that decision. Not in a confrontational way, not in an angry way. But if it's a really good financial decision,

then hopefully the couple can talk about it and get on the same page. And if it was a hasty decision, perhaps that discussion can help turn that around or at least give some time for pause and thought. Have any of the classic rules of personal finance changed? Well, personally, in my personal research, I'm really interested in individuals' use of rules of thumb. So one of my research, projects that I'm currently working on is trying to identify if these rules of thumb have ever been helpful to us. I'm looking at which rules of thumb people actually use and whether or not those correlate with financial health. So I think the answer to your question, what is it depends on what rule of thumb people are using. Okay. What are some of the common rules of thumb that people

often use? Well, there's a lot and there's very success of each, but things like buying the amount of stocks or based in the amount of stocks that you have in your portfolio based on your age. And there's various calculations of how you can calculate, how you can use your age in a calculation. Or there's things like always pay off your debt before you start to invest, no matter how much debt you have or no matter what interest rate you're paying on that debt. Or, for example, never taking on a credit card debt. So it sounds like you are looking at these classic personal finance principles and seeing how they correlate with financial health. Exactly. And what are some of your preliminary observations?

Gosh, I haven't actually had time to look at the data yet, which sounds terrible, but I was in the process of doing so, and then volatility hit. And we've really tried to change our strategy around to focus on content and helping investors deal with this volatility. So I don't have much to say on that just yet, unfortunately, even though I think it's so fascinating because I think there's so much promise behind rules of thumb, because they're easy for people to understand, easy for people to follow. What I want to do is make sure that it actually helps people in the end.

Has there been previous research on the same topic? Not exactly. So I know a lot of the research I've looked at in the past tested out, either identified roles of thumb people to follow, but it didn't really have any theory or facts behind that or data behind that that supported those roles of thumb, or looked at people's decisions to see what roles of thumb they used. But no one's really made that connection between looking at a rule of thumb and seeing if it helped people.

And I think it's because it's hard to do. One, because you have to do some sort of experiment forcing people to use a specific rule for an extended period of time and seeing how it impacted their finances. So logistically, it's just hard to do. And also because financial success is such a weird thing. It's hard to define. Is it financial success because you bought a house when, or you were able to retire, really early, or is it because your income is very high, or is it your debt-to-income ratio? So I think there's been a lot of issues with asking and answering that question fully.

Right. How do you define a successful outcome? How do you define financial health? Correct. I mean, also is it a matter of happiness? Is it a matter of reaching one's goals? And what does it mean if someone, as they reach their goals, they shoot for higher goals? And so what we find is that it's, well, it's easy to make some, to say people should pay off their lowest balanced debt first. They should pay off their highest interest rate debt first. And they make perfect sense when you think about each one individually.

And then you realize that they contradict with each other. Like, no, no, no, this can't be right. You can't have two universal truths which disagree with each other. This is the hard research that Sam and the team is working on, is to try and understand how do these really relate to actual financial outcomes and the different ways that we might formulate it. Now, I think as we get out of the kind of the detailed ones, there are obviously some which are probably more robust,

like don't go horribly into debt. And sadly, this is a time when a lot of people just don't have a choice. I mean, we can know in our heads that we shouldn't get in a bad situation and we shouldn't run up our credit cards. And these are times when if you've lost your job, your spouse has lost a job, or your, gotten really sick and you don't have medical insurance, then even the best rules of thumb in the world aren't going to help because the reality is that people struggle. I've also heard people at this

time make the argument that a person should strategically go into long-term debt right now. So I've heard people make the argument that because interest rates are so low, this is the time. To refinance your mortgage into a lower interest rate, I think that makes a lot of sense for people, but also to take out a HELOC or to start putting your purchases on a 0% introductory teaser rate credit card so that you can free up your cash for other purposes? Absolutely, if that were the only thing we did. The problem is we're human beings. So if I were to take out a HELOC, am I going to just sit on that money? Am I going to invest all of that? Or am I just going to, you know, take a fancier vacation once the quarantine lives.

Maybe I'm going to splurge a little bit on a house renovation that I wouldn't have otherwise. The problem is we're just complicated beings and the action we take in one area may make perfect sense, except for the fact that we counterbalance it in another area. And the net effect on someone's finances, for example, of taking out of HELOC right now, or refinancing, especially if you're refinancing with cash out, it's a lot more murky than that. And we need rigorous analyses like Sam was talking about to really peace out. Is it helping people on net or not? We know that we know the individual effect.

It's really hard without some careful analysis to figure out the net effect. To what degree does compartmentalization play a role in that decision? So for example, let's say a person were to take a cash out refi against their primary residence right now. And that cash out refi resulted in a lump sum of $50,000. And they took that lump sum. and they used it to make some very positive financial decision. Let's say they purchased a $50,000 single family home in cash that they could use as a rental property, right? So it would be very easy to say, you know, the 50K from bucket A went to purpose B and therefore I handled it responsibly.

How can a person develop the knowledge and the self-awareness to be able to assess other financial decisions that they make in other areas of their life, which may be affected by that such that they're not over compartmentalizing that. Well, there are a couple different strategies that one could use to think about that compartmentalization. One is to preload, to preload your choices and say, okay, this is part of a package. I'm going to take a cash out refi of $50,000, and I am putting every dollar automatically into this account. This account can only be used for this purpose. And you write all that out.

If you're working with an advisor, you give it that to them. If you're working on your own, you give it to your spouse. You give it to your cat. You give it to anybody, right? You just make sure somebody's got that to keep you on track. So that's one is treat it as a package and make sure every dollar is accounted for. Don't do what, to be frank, I've sometimes done in the past. Put it in the checking account and then I transfer most of it, but I'm going to use some of it to pay off this debt, which, you know,

I was going to pay off later anyway, but since I paid off earlier than I, you know, didn't have to save so much later. So you get rid of all that messiness. And you preload it and say, okay, this is everything I'm going to do. Second, there is a fascinating literature on how we lie to ourselves. On how we self-deceive. On how we absolutely intend and make the choice to, yes, this, I'm going to use this to help improve my finances. I'm going to pay off my high credit card debt. I'm going to do all these things.

I'm going to do nothing else. And tell, of course, there's an exception, etc. What that literature tells us is, well, if you're smart, if you're creative, you're in a lot more trouble. Lying to ourselves comes from creating a narrative in which we can still be virtuous people and do this thing that we want to do. Go splurge on it, right? Rack up a little bit more credit card debt than we would otherwise because we know this cash is coming in, et cetera. And other than making ourselves less creative and less smart, the technique is to create. create bright lines so that it's very, very clear to yourself and ideally others when you are

breaking your own rules. So you externalize. You write down. These are my rules for credit card. This is what I'm going to do. And so it's harder to tell yourself, no, this is just an exception. This is just one time you've got the rule staring you in the face. And so that's the second thing we really need to watch out for with this compartmentalization is that, well, we fudge things. And Dan Ariely has a great book that summarizes this called The honest truth about dishonesty. I love the book. From what I can tell, I think it's probably his most important book and the one that's least popular. And that topic that you've just brought up, the self-deceit, the ways in which we, particularly if you're smart, if you're creative,

as you said, we can rationalize our irrationality. How can we be aware in the moment of the distinction between reason versus rationalization? Sure. The idea of a pre-commitment is a way of locking ourselves in when we're feeling pretty calm and confident to avoid temptation or avoid making that mistake later on down the road. So when it comes to investing, there are some a little bit of harsher techniques we can take so that could be making an investment you can't legally sell for 10 years. But one of the things we like to talk about in our research is suggesting that investors or people, write down a letter to their future selves. So when you're feeling calm and relax, write down what your goals are, what are your values? For who are you doing this for? Why is it so important for you to stay on track no matter what sort of volatility hits the market, some future time? So that when there is volatility and investors might need that reminder, they can pull out that letter to their future selves and really remember why their investments and their strategy are on track and this volatility is not going to affect them too much, as long as they don't give into their temptation along the way. And so kind of implicit in that is the best way to know if you're being rational or not in a heated moment is to compare to when you know you made a rational choice. So it's a matter of preparing yourself for that moment. And that's great if you've

prepared beforehand, right? And that's what a pre-commendment or does. But in the moment, you can also look and see, are you anxious? Are you able to see the other side? Are you able to think of, if you're buying a house, why is someone selling? Why are they selling at that price? If you're buying an investment, why is someone selling? If you're selling, why they're buying, et cetera. And that's, if you're not able to see another perspective, you're probably tunneling in

in that moment. And that's a warning sign. And some of them are just basic grandmother's common sense. which we all forget. If you're tired, if you're exhausted, well, probably you're not going to make the best choice. And so it's hard to really second guess our own decision in the moment, but we can look for how we're feeling and use that as a warning of,

hey, maybe the decisions I'm making aren't the best. And putting aside personal finance, putting aside investing, look, we've all been there when in our personal lives, we're in a situation like, I don't think I'm going to make good choices here. And I'll leave that to the listener's imagination. We've all been there. And so how do we recognize that? In our daily lives, it might be drink.

It might be being up really late, might be being with certain good of friends, et cetera. And we start to learn as we grow those signs in our daily lives. And we want to look for the same, what are those signs in our financial lives? Stress, anxiety, not willing to talk with anybody else. else about this big thing I'm going to do. Being overly excited. Like, I got to do this right now. If you got to do it right now, it's probably not a good idea. Right. And so it's kind of a knowledge of self that we gain over time. We'll come back to the show in just a second. But first, circling back to biases, which is how we started this conversation, it strikes me

that being influenced by biases that we are not aware of is one way in which we deceive ourselves. So can we go back to talking about, you know, what are some biases that the people who are listening to this episode should be aware of? We've talked about recency bias, confirmation bias, action bias, and hurting behavior. Oh, and overconfidence. And overconfidence. Yes, the one that I that I struggle with with my investing. How can we distinguish between confidence and overconfidence? One thing I would want to ask, I see that what we're trying to do is help people make the distinction between a biased decision and a completely logical rational decision. Making the distinction between these two types of decisions is extremely hard because we're human.

We can't really see our own biases. So what I would recommend is not try to anticipate bias or point out a bias in a decision, but prepare for them. And by doing that, you're completely making the bias irrelevant. by either avoiding the bias altogether or overcoming it in some other former way. I think the point that we're trying to really pin on here is not exactly trying to see the difference between a bias and an unbiased decision, but really prepare for a bias is no matter what it is, no matter what the situation is or no matter what you're going to

face, but setting up the decision-making process in a way that you possibly never have to see your biases. And one way to do that would be like creating the rules. Steve mentioned earlier, slowing down the decision-making process or trying to explain the opposite before acting. So these sort of strategies help us avoid our biases before we even encounter them. Most of the behavioral techniques that researchers have come up with are fundamentally about changing the environment so that we can make better decisions rather than changing the person so that their decisions are better. Because we're all human and that ain't going away.

We make these shortcuts. These shortcuts are very useful. Sam mentioned in the beginning are really useful in our daily lives, so they're not just something we can stop. We're never going to stop looking at what other people do and taking that as a cue. So if that creates a problem, for example, in investing, the solution often isn't to tell yourself, don't think about other people are doing.

Don't think about what other people are doing, right? That's very difficult. Instead, we see, how can we cut out that information? How can we change our environment so we don't see what other people are? doing. Or we look to a better reference group, right? We use that bias to our advantage. So, for example, if I were to look at a variety of very loud news, stretching it, calling them news folks, very loud people on TV talking about what the stock market is doing and what I should be doing right now, then I'm setting that as my reference group and I'm taking cues from them. Best solution isn't

for me to watch these folks and say, no, I'm not going to do that. I'm not going to do that. It's not to watch the show. It's to structure my environment, so I avoid that. Right. So I very intentionally read Morningstar.com because I want to set that reference group of people who look at fundamental value, look at the long term, et cetera, because it kind of reinforces that. And I know there are lots of other reference groups I could use. I could look at the crazy ads about people being jealous of someone else's yacht and feel that if I just invested, you know, if I just invested better, I could have a yacht too. And it ain't going to help me. And so that's part is how do we change our environment?

There is also some literature, and it's more nascent, on using mindfulness techniques, actually, to help recognize and allow these bad decisions to pass. Again, it's very difficult for us to simply stop the exercise of willpower against the wiring of our minds is a difficult thing. But there's rigorous research on using techniques from mindfulness to recognize a negative urge like selling in a panic, et cetera. And not getting rid of it, but just saying, okay, yep, that's there. I'm just not going to act on it. And so that's a very different type of approach as well. You talked about evaluating reference groups. Some may be better than others. How can a person, evaluate and determine what's a better reference group without succumbing to confirmation

bias and group think. Oh, that's a good one. Well, one is, how does it make you feel? If it makes you feel really smart, watch out. If it makes you feel like you got to do something right now, well, maybe watch out. If the tone is thoughtful. And if you learn something, but it's not, well, the world is completely different. Now I have the inside secret. then okay. And some of it is choosing by reputation. So you look around and say, if I ask people not what to do, but who do they look for for thoughtful advice? That's a step removed from those immediate emotions. And let me see how do they attack this, right? How do they think about this? A lot of people, when you ask them that question, for example, in investing will say, I look to Warren Buffett.

But if you look at their individual behavior, of course, they're not following Buffett. And that's getting from them as a group to who they say, okay, yeah, this, in my ideal, this is the person I would look to. And okay, let me go check out what Buffett's saying. Let me see how he's attacking problems. We are coming to the end of our scheduled time. Are there any key takeaways or core ideas that you want to emphasize or that you want to leave this audience with? One thing I would like to emphasize is that these shortcuts, our minds take, aren't evil. In fact, they help us make a lot of daily decisions. However, when it comes to our finances, they can lead us to those wrong conclusions. And instead of just trying to hide from our biases or trying to tell ourselves

to make a logical decision, there are things we can implement or strategies or techniques we can implement in our regular investing decision-making process to help us avoid our biases when it matters the most. And that could be techniques like taking a step back and creating a three-day wait pool or discussing it with a partner or a friend before making a decision, or even creating that pre-commitment letter to help remind ourselves while we have to stay on track when it matters the most during volatility. So preparing for our biases and not exactly just waiting for them to come. That's really well said. And I think we're human beings. We can't think through every decision in minute detail. And so we take shortcuts. Sometimes they lead us astray. We can't stop taking

shortcuts. We can choose them for a few times in particular situations, okay, let me try and do this more calmly. Let me do this better. But often the solution isn't to become less human. It's rather to change our environment, to change the information we have

and how we structure a choice through pre-commendment, through cool down, etc., as Sam said, in order to bring out a better part of our humanity and how we can make good choices rather than fundamentally change who we are. And thankfully, that's not just a hope. That's a reality. We see this in behavioral studies. We see this in rigorous,

randomized control trials. People can change their decision-making environment. They can make better decisions. And I think that's quite powerful. Thank you so much for spending this time with us. Where can people go if they want to know more? You've mentioned morningstar.com, of course. Are there any other resources that you would like to send people to? So many of the articles that Sam has written are available on Morningstar.com. So that's a great point. It's not just the website overall, which is wonderful. Outside of Morningstar and particular Sam's writings, which are excellent. There are two books that I really like in the finance space. One is the dumb things that smart people do with their money. And particularly in the investing realm, it's Montier's book, the little book of behavioral investing. It's been around for a while, but it is, still a wonderful short summary of the behavioral challenges that we all face and some thoughts on how we eliminate those. Excellent. Well, thank you. We will link to all of that in the show notes. Thanks to both of them for joining us. What are some of the key takeaways from this discussion?

Here are eight, and we'll divide these into two buckets, five common biases that skew our decision making, and three techniques that can help us save ourselves from ourselves. bias number one, recency bias. We tend to believe that whatever happened recently will continue to happen. If the market is going down, we think it'll continue to go down. So naturally, when we're trying to predict the future or make a decision, our mind naturally thinks about what happened most recently. Unfortunately, this is the type of thinking that prompts selling during a downturn.

If the market is going down and due to recency bias, we assume it's going to continue to do so, then we might sell in the middle of a crash, thus converting paper losses into real losses, in order to avoid additional losses. At least that's the bias and that's the flawed thinking. Because what actually happens, as we know, based on a lot of data comparing the performance of buy-and-hold investors

to those who try to time the market and jump in and out of the market, what we know is that those who hold on average and over the long term tend to do better than those who jump in and out of the market. But it's hard to avoid the temptation

to try to time the market. It's easy to rationalize selling during a downturn and one of the primary ways that we rationalize that is through recency bias. Another way in which we see this play out is that we assume

that the next crash will be similar to the last one. So when this particular bear market, the March 2020 market crash happened, a lot of people started asking, is there going to be a housing crash? The Google search queries for will the housing market crash exploded through the roof in March 2020 when the spare market struck.

Why? Because people assume that this downturn will be similar to the last one. And the last one was triggered by subprime lending, which allowed unqualified or poorly qualified borrowers to take out mortgages that they could not afford, which they then defaulted on. So the factors that led to the 2008 crash were embedded in and intrinsically tied to the housing market. And that subprime lending, coupled with all of the mortgage fraud that was also happening, due to loose lending standards, triggered a housing crash that went, in our minds, hand in hand with the recession, hand in hand with that market crash of 2008.

And so, fast forward 12 years, it's 2020. Now we have another market crash. This crash has nothing to do with the housing market. It didn't originate there. This crash was triggered by a completely different set of factors, and yet, people, many people, assumed or worried that this crash would also affect housing in the way that 2008 did. Why? Recency bias. We assume that the next crash will look like the last crash, and we let those mental associations override basic critical thinking about the fundamental of what caused each crash. Similarly, many of us assumed that we were not at risk of a pandemic.

Why? Because the last two major pandemics that affected people in the United States happened in 1957 and 1918. Both of those happened long enough ago that recency bias did not allow us to bring those pandemics to mind. It belonged so deep into history that even though epidemiologists have been warning us for years, years that we are at risk of a pandemic that the next one is around the corner,

recency bias makes it hard to believe that. Because how could we possibly be at the level of risk that the epidemiologists are warning us about if it hasn't happened in so long? That's the cognitive bias talking. We underestimate the risks when something has happened long ago when it has not happened recently, and we overestimate the risks when something happened recently. And so that, recency bias, is bias number one in our list of five biases that we are particularly susceptible to during times of high anxiety or high stress. Bias number two.

Confirmation bias. We are likely to seek out information that reflects what we already believe. If we think that we are heading into a severe recession or perhaps even heading into a depression, we are likely to seek out sources of information that reflect that and that validate our current thinking. Likewise, if we are prone to believing that we will make a relatively quick recovery, that we will reach Dow 30,000 in the next one to two years, if we're prone to thinking that, then we are likely to seek out sources of information that will corroborate what we already think.

naturally our minds pay more attention to, news and facts that happen to agree with our opinion. So how do we avert some of that confirmation bias? One is we can challenge ourselves to read a news article or watch a YouTube video or listen to a podcast that disagrees with our opinion and to take in the viewpoint that's being presented with an open mind. That's one way to do it. Another way to do it is to wait for a few days and then explain your viewpoint to a thoughtful and well-read person who may disagree with you. And so confirmation bias is the second of five biases that we are particularly susceptible to when there's a pandemic happening.

Bias number three. Action bias. When there is a disaster unfolding, we want to do something. We want to take action. We don't want to just sit there. And so we will bias towards taking action even if we would have been better off doing nothing at all. This is our tendency to want to take action. So when we see our portfolios losing money, for example, we want to stop the bleeding.

Many people, when they see their portfolio declining, you see your 401K dropping, you see your IRA dropping, you see your taxable brokerage accounts getting beat up. You want to jump in there. You want to jump into that fight. And that action bias leads a lot of people. People who were buy and hold investors during the bull market suddenly become market. timers during a bare market. There's an expression, in a bull market, everybody thinks they're a genius. Because when the market is in your favor, then many people can make suboptimal decisions and still see gains. And they interpret those gains as a sign of their own investment savvy,

when in reality, there is a disconnect between the soundness of the decision-making process itself and the result or outcome. A suboptimal decision may lead to it an otherwise suboptimal outcome, which is still expressed as a gain. So it would be a suboptimal outcome insofar as it carries steep opportunity cost, but people don't evaluate their results in terms of opportunity cost. People evaluate their results relative to where they were in the past. And so if their current results are a gain relative to where they were in the past, then it can be easy to develop overconfidence, which is another bias that we're going to talk about in a minute, and to believe that their gains are a reflection of their talent and skill as an investor,

rather than simply a reflection of the fact that we are in a bull market. Hence the expression in a bull market everyone thinks they're a genius. But then the wins change. The market crashes, as it did last month. We find ourselves in a bare market. We can tell that we're almost certainly in a recession. and even though we have heard ad nauseum, hold your holdings, don't try to time the market. Even though we've heard that advice for years, we still want to jump in there, we still want to start

tweaking things, we still want to time the market. That is action bias at work. So if you find yourself falling prey to action bias, here's what you can do. Rather than deny it or suppress it, you can funnel it into the action that is most likely. to have a positive outcome, and that action is saving more. That might mean increasing the contributions to your 401k or your IRA. That might mean shoring up your emergency fund. But it is your contributions, not your market timing, but your level of contributions

that are the single biggest determinant of your investing success. So contributing more into your investing accounts, tweaking your monthly automatic deposits such that they're 1% or 2% or 3% higher than they used to be. And letting that continue on in perpetuity from this point forward, such that you'll be making those higher contributions for years to come. That is how you can express action bias in a positive way. So that's bias number three, action bias. And since we touched on overconfidence as we were describing it,

let's talk about overconfidence as bias number four. Here is what Dr. Steve Wendell has to say about. that? I'm a contrarian investor. I look for the fundamental value of a company. I look at the current price and I see, okay, where is there an opportunity? And I find myself slipping into, well, hey, maybe because I'm a contrarian investor, I've got this special knowledge that the rest of the market doesn't. The vast majority of people think that they are above average, which, statistically speaking, cannot be true. By definition, only 50% of people are above average. And yet time and again in survey after survey, regardless of whether people are asked about their confidence in themselves

as a driver or as an investor or in any other skill set, far more than 50% of people think of themselves as above average. In one study, 65% of Americans said that they considered themselves to be above average in intelligence. In another, 32% of employees of a particular software company said that they believe that they perform better than 95% of their colleagues. So 32% of people believed that they were in the top 5%. This is a concept called illusory superiority. So what can you do to overcome the natural cognitive bias of overconfidence? Well, first of all, if you find yourself forecasting, stop.

Any attempt to predict the future is partially rooted in the overconfidence bias and is likely to be wrong. Humility comes, in part, from knowing that we do not know, that nobody can accurately predict the future. So rather than forecasting, focus on what is the current situation? Where is the market currently?

What are stock prices, bond prices, housing prices currently? What is your personal financial situation currently? Do you have a big enough emergency fund? What is your debt position? Take a look at the current reality and make decisions based on what is, not what you think will be. Warren Buffett never buys at rock bottom and sells at absolute peak.

He simply buys when it's a good deal to buy and it makes sense. And he sells when it's a good deal to sell and it makes sense. He doesn't worry about trying to time the peak or the trough of the market. He simply buys when it's sensible to do so and sells when it's sensible to do so. The rest is just noise. I've said this many times, by the way, about the housing market. People often get so caught up in those numbers in the valuation of their home. Oh, I went on Zillow and this estimate for my house went up 4% in the last month.

Who cares? There are only three points in time when the value of your home makes any difference whatsoever. When you buy, when you sell, when you refinance, everything else is just noise. So stop forecasting about the future, take a look at what is. If this applies in the world of stocks and real estate and any type of investment, take a look at what is and do what's sensible based on the current reality. That is how you can avoid the bias, as Steve described, of thinking that you have special knowledge that the rest of the market doesn't.

And finally, bias number five. Herding behavior. When we're unsure of what to do next, We tend to follow the crowd. When we're not exactly sure what to do, technically or usually on an everyday basis, we look to the crowd and we follow the crowd. The problem with this strategy is that the crowd is broke. The majority of American households don't have a high savings rate. They don't have an adequate emergency fund.

They don't have adequate funds in their retirement accounts. And of the money that is in their retirement accounts, of the money that they do have invested, they often tend to mismanage this. They sell when the market is crashing, thus converting paper losses into real losses, and then they wait too long to take part in the recovery, thus missing out on all of the gains of the recovery. So following the crowd, going along with the herd,

is not sound financial decision-making. Instead, as Sam and Steve suggest, look to your goals. What are your financial goals? Do you want to buy a house? Do you want to pay for some big, ticket items, such as paying for a wedding or sending your kids to college, or paying cash for your next car? Do you want to retire within 5, 10, 15 years? What are your goals? How much money do you

need to get there? How many years into the future is each goal? You start with that and then work backwards to see how much you'll need to earn and save, and what types of risks you should take within your investments. This way your financial plan is personalized to you and not simply, an act of hurting behavior. So that is bias number five. Let's close out by talking about three techniques that can help you make better financial choices during times of high volatility. Technique number one is to preload your choices. To preload your choices and say, okay, this is part of a package. I'm going to take a cash out refi of $50,000, and I am putting every dollar automatically into this account. This account can only be.

be used for this purpose. Before you encounter a pile of cash, and that pile of cash might be your next paycheck, it might be a commission or a bonus that you make it work, it might be money that you take through a cash out refinance, any time that you are going to deal with a pile of money, even if that pile is as routine as your next paycheck, preload your choices so that every dollar has a job. You know exactly where every dollar is going to go. That is technique number one. Technique number two, pre-commit. The idea of a pre-commitment is a way of locking ourselves in when we're feeling pretty calm and confident to avoid temptation or avoid making that mistake later on down the road. Write a letter to your future self. What are your goals? What are

your values? Why are you focused on managing your money well? Why are you doing this? Who are you doing this for? Why is it important to stay on track? Pre-committing your decisions. can help you avoid distractions as the months and years unfold. For example, if your goal is to buy a rental property within the next two years, then you might make the pre-commitment to save $1,000 per month into a down payment savings fund, pre-committing to that and then writing a letter to your future self, the you that will exist 24 months from now. That can keep you on track.

And technique number three, prepare for biases ahead of you. time. And you can do that, number one, by listening to this podcast where you learn about what those biases are, and you learn the names of those biases so that you can describe them, you can articulate them. Often, once we have the vocabulary for a particular concept, then that concept becomes a greater part of our awareness. Once we have the vocabulary to describe illusory superiority or recency bias or action bias, then we become more likely to be able to recognize it when it plays out in our lives, or in the lives and decisions of people that we know and observe. So that is one way to prepare for biases ahead of time. Another way is to create

a set of rules for ourselves, a written set of rules that states exactly what our investor policy statement is. How will we handle our money? How much will we save? What percentage of our income will we save? And where will those savings be directed? How large of an emergency fund will we maintain? What type of asset allocation will we have? How often will we rebalance? And will this be done automatically or manually? How often will we track our net worth? Writing out this set of rules can help us avoid acting on impulse or falling prey to our biases later. One way to do that would be like creating the rules, as Steve mentioned earlier, slowing down the decision-making process or trying to explain the opposite before acting. And so those are five

cognitive biases and three techniques for dealing with them. If you are working from home right now, as many of us are, and you are struggling to maintain your focus and stay productive in the middle of this pandemic, we have a free guide to pandemic productivity. You can download it for free at afford anything.com slash productive. That's affordanything.com slash productive. It is an e-book for free that gives you more than 30 tips, 31 tips, to be exact, that can help you stay on task, stay focused, meet your responsibilities despite the distractions of working from home. So again, check out this guide to pandemic productivity at afford anything.com slash productive. That's affordanything.com slash productive.

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