The Compound and Friends - The Stock Market Doesn't Care How Hard You Try (with Barry, Michael, and Morgan Housel)

Episode Date: December 3, 2019

The incredibly bright and insightful Morgan Housel of the Collaborative Fund drops by the Compound to discuss some of the biggest mistakes and misconceptions that plague investors year after year - and what can be done about them. Morgan talks with Michael Batnick and Barry Ritholtz about: * how there is no such thing as an optimized portfolio * why recent trends are more instructive about the near term future, but long term trends are the ally of most investors * the fact that investing is one of the only endeavors in which the application of more effort doesn't equate to better results * the hindsight bias that all of us fall victim to * the reality behind some of the most famous investor track records * the inconsistency you are required to put up with in the pursuit of long term outperformance 1-click play or subscribe on your favorite podcast app   Subscribe to the mini podcast on iTunes or Spotify    Enable our Alexa skill here - "Alexa, play the Compound show!"   Talk to us about your portfolio or financial plan here:  http://ritholtzwealth.com/   Check out our video channel, "The Compound," over on YouTube: https://www.youtube.com/thecompoundrwm Obviously nothing on this channel should be considered as personalized financial advice just for you or a solicitation to buy or sell any securities. Please see this 3,000 word terms & conditions disclaimer: https://thereformedbroker.com/terms-and-conditions/ Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

Hey, it's Barry Ritholtz. I'm here with Michael Batnick. Our guest this week is Morgan Housel, and we're going to discuss the three biggest mistakes investors make. Welcome to The Compound. Morgan, thanks for coming in. Thanks for having me. So you write a lot about behavioral finance and economics. As do you. As do I. Mike occasionally dabbles in this space. It's a scam.

Right. Well, according to Gene Fama, the whole thing is a fraud. So I wanted to ask you a question. What do you think are some of the biggest mistakes investors make from a behavioral perspective? We could sit here all day and talk about the dozens of ones, but a few that stick out to me, one that I think is maybe like the grandfather of behavioral mistakes is the idea in investing that results are going to be correlated with effort. And it's a really innocent mistake because investing is, I think, one of the only endeavors where the correlation between effort and results is not that strong. But almost everywhere else in life, if you want to do better at something, you put in more effort. Like we know in investing, if you can just dollar

cost average and leave it alone, you'll probably do good, if not great, if not like top quartile. But imagine like what other industry is like that? Could you imagine telling a football player, if you want to get better, just sit on the couch, don't do anything? You're describing every doctor I've ever spoken to who wants to transfer their intelligence and hard work into investing, and it just doesn't work. This is why it's so pervasive, is because it's a really innocent mistake. Because like I said, every other area of life, that is the case. The harder you try, the more effort you put in, the better you're going to get. Like I brought up the example of like Tiger Woods.

There's stories of Tiger Woods when he was like a teenager going to the range and hitting a thousand golf balls. Or Michael Jordan would go to the practice court and just dribble for like 10 hours without ever shooting. I just read that Robert De Niro watched The Godfather 50 times before the second one. Seriously. Just over and over again. Yeah. Is that true? Seriously. Yeah. I don't know if it was on a loop. He might've taken a break. But like there's no, there's nothing else in life where to do better. You should just stop trying. But there's a lot of evidence that investing that's the case. And I'm not militant and passive,

but even to the people who are successful at adding alpha over time, I think it's by and large people that know the limits of their effort being put into it. And they're seeking alpha in ways that are super simple. Go back to Buffett's, Buffett can make a decision about an investment in an hour or two. Part of that is just because he's been doing this so long that I think his heuristics of getting to the right answer are so clean. But I think part of it too, is he's just focusing on a half dozen variables and the super deep complex analysis just isn't necessary. So even, even in that situation of like successful outperformance, it's knowing the limits of putting your effort in. And I've, I've thought about, I remember years ago, I read that Bill Ackman, when he was doing his research on Herbalife, spent $25 million on diligence, which even for Bill Ackman, that is a lot of money, $25 million to do research on one company.

And I thought, like, how, is it even possible at that point to be unbiased about it? Or do you think you've put in so much effort into this that you have to be right? It's worse than that. And I wasn't going to bring the endowment effect as one of my biases. But since you brought this up, there is a little amount of information it takes for you to become knowledgeable about a company. Everything else that you're learning, all it does is you're sharing information that's already publicly available and known and therefore already reflected in the stock price. But what it does is it adds to your level of overconfidence. You think you really know the stock, plus you put so much time and effort into it.

Totally. It's very hard to just- Wipe your hands. Just walk away. So you have the endowment effect and you have the sunk loss fallacy all wrapped up in this little, hey, people think that effort and performance are correlated. So what are the odds that Bill Ackman or any of us after spending $25 million would say, yeah, there's nothing here. Walk away. You're either long or short. Zero. So you talked about the grandfather. What's the second cousin once removed of behavioral mistakes? I think if you

wrap up timing into a couple of components, one is just underestimating the amount of time that's probably necessary to put the odds of success in your favor. Not the guarantee, but the odds of success. I think people underestimate that. Compounding or just letting things work out? Just letting things work out. An example is most investors, if you ask them, will claim to be long-term investors. I think the overwhelming majority of people will say, I'm a long-term investor. Nobody says they're short-term.

Very few. Some will, but a minority. But then if you ask- Only professionals say they're short-term. Very few. Some will, but a minority. But then if you ask- Only professionals say they're short-term. That's true, right. But then if you ask people who claim to be long-term investors, what does long-term mean? What is the definition of long-term? What's your average holding period? Or what time frame are you thinking about? A lot of people will actually tell you one year.

Yeah. Oh, really? Or even here's an example of this. The Fed has a survey where they put out expectations for long-term inflation expectations. Their definition of long-term inflation expectations, their definition of long-term is three years. So I think that's a pretty common thing. Or especially if you're heading into retirement, like five years or 10 years is definitely the long-term. But if you look historically, like what is the holding period in which historically every holding period finishes

with a positive return? What do you mean by that? If you go, if you look historically in every rolling period, what is the amount of time that's necessary in which every rolling period finishes with a positive return? Now, does that include dividends reinvested and inflation and inflation, dividend and inflation adjusted? And look, that's rare. That happened, I think, in the 70s. No, I think it was actually in the 70s, in that stretch of terrible returns. But it's happened. And periods where you've gone 10 years or more with either negative or crappy returns. Let me push back.

You think that that's a mistake? Like, is it realistic that somebody has an 18-year holding period? No. But that's a perfect segue into the other part of timing. It's just not the implicit expectation that the market knows and cares about your specific time horizon. Right. Like it's relevant. So you can tell people like, look, to do well in the stock market, you need 20 years. And that person might say, well, great, I'm retiring in four. I'll give you six months. But no one cares about what your time horizon,

the market does not care how much time you specifically need. And I think it's like, no one actually thinks like the market owes you something, but they implicitly think, I'm going to retire in five years. So these are the returns that I need to occur in the next five years. But the market's going to do whatever it's going to do without, it doesn't care anything about you. And I think a lot of smart people, I've fallen for this myself of like, okay, so I'm saving in a 529 for my kids. My kids are going to go to school in 16 years. So these are the returns that I'd like to earn between that. But right there, you're falling for a trap of like, this is, I'm personalizing my goals with whatever I think the market's going to do. And I think that just,

if you really wrap your head around that the market's going to do whatever it wants to do and does not give a shit about you, then I think it just, it necessitates a longer hold period than most people think. Really interesting. Mike, what are you looking at in terms of big behavioral mistakes from the man who wrote the biggest mistakes by the best investors? I'll plug your book. Thank you. Thank you for the plug. All right. So I've got, I've got a few, and I think these are not necessarily like the biggest mistakes that cause the most amount of pain, but I would just say maybe like some of the most common mistakes. So Jason Zweig wrote about this,

that people often learn the wrong lessons and specifically they learn lessons that are over-precise. So in the dot-com bubble, they didn't learn not to day trade. They learned not to day trade internet stocks. And then they went on to currencies or whatever. House flipping. Yeah, yeah.

I think in terms of risk, people either take way too much or not enough. Not enough is a huge problem amongst people who have substantial assets risk, people either take way too much or not enough. Not enough is a huge problem amongst people who have substantial assets, but aren't multi-gazillionaires and they need to see actual compounding over decades. So the Dalbar study that we all know has its issues shows that the behavior gap is massively wide. And I think that might be overstated, but I think that the overall portfolio gap is- Whatever the behavior gap is, maybe it's not Dalbar's number, but it's big.

But I'm saying it's understated because that only accounts for the money that's actually invested. If you include the amount that people have in cash, they're underperforming even bonds by a drastic amount because people are just risk averse. But can I bring up a counter to this that was actually one of my others? I think another big mistake that people make is the assumption that there's one right answer to most investing questions. Like, is this stock cheap, yes or no? Or is this allocation proper, yes or no? And I think the flaw in that is that

the right answer is just whatever works for you personally. So I've written about this. I have a higher cash allocation than I think any financial advisor or any model would say is reasonable. What is your cash allocation? So my cash allocation- And are you sitting in cash

waiting to make a down payment somewhere? He's waiting for a fat pitch. Waiting for a fat pitch. My cash allocation, I have four times as much stock as cash. Does that make sense? So you're 20% cash. And the reason is because.

You need a financial deposit. No, the reason is because it helps me sleep at night. I'm fully aware of the returns that I'm giving up. And I know what it's going to cost me over the long run. I know that my stocks

are going to earn a much higher return than the cash. But I want to optimize for just going to bed at night and looking at my wife and kids and saying, no matter what or almost anything that could hit us reasonably, we'll be okay. We say this to people all the time. The optimal portfolio isn't the one with the highest returns. It's the one that you can live with. If you have a fantastic portfolio, but it makes you so nauseous that in March 09, you sell everything. And we've gotten emails from people, hey, I got out when you guys were very negative in 08, 09. And here it is

five, 10 years later, I'm still sitting in cash. You can't recover from that. So you have to be able to live with it. And also in terms of there not being one right answer, I would not recommend my allocation to most people of my age and income. It works for me, but it might not work for you. But I think the assumption that there should be one right answer causes a lot of debates in finance that aren't actually debates. Like we're not saying, are you right or wrong? People are just saying, well, this works for me, but this works for me. And it's fine if there's distance between us. Half of the battle on Twitter are between people who are investors and people who are traders.

And they argue about different things. It's wildly different targets, goals, risk tolerances, and timelines. Of course, there's a lot of different answers. One other thing that I had down was that I think that, I don't know anybody that's necessarily immune to this, is people often think that the recent past or that the future will look like the recent past. Or even long-term classic recency effect yeah this is something i've been

accused for and i think it's a decent criticism is looking at long-term history and using it as at least a proxy for what's likely going to happen in the next 50 years and if you know anything about history you know germany was a really civilized, good society in the generations before World War I, World War II. And then, you know, there's a long history of countries wiping themselves out. And the last 50 or even 100 years that we've had in the United States is no guarantee of what's likely going to happen. I think it's a good proxy and it's a good first approximation of what's likely to happen. But the assumption that even the long-term history is a good predictor of the future is— When we look at the long-term history of things like valuations,

there are some pretty reasonable arguments to make why buying a software company in 2019, you shouldn't pay the same multiple when you were buying a steel company 100 years ago with the cost of labor and the cost of capital goods and setting up physical factories. Now it's literally two guys, a laptop, and Amazon Web Services, and that's the next billion-dollar company. So maybe a higher P.E. And I don't want to justify expensive stocks, but maybe on average- Higher than it was in 1890. Right. Go back a century, there's a reason why the average PE has crept up over a century. And this is a point that the pseudo-anonymous blogger Jesse Livermore has made that there's kind of like a poo-pooing of recency bias that people are only

concerned with what happened in the last couple of years without an appreciation of history. But there is a point, like there's a balance between the two that if you really want to look for things in the data that are likely to be relevant to the future, the recent past is more relevant than the long past. And there's things of like the long past of history that are always going to be the case. These things are just embedded in human nature. But if we're looking at specific things like PE ratios or profit margins, the recent past is going to be more relevant to the future than anything that happened, you know, in 1872. The only thing I can tell you, there's a guy named Wyckoff who wrote a book in,

I want to say 1923, How I Trade Stocks and Bonds. And if you just substitute internet for railroad and semiconductors for telegraph, nothing else has to be changed. It's unbelievable. One of the reasons why I guess Fama's cranky about behavioral finance, and I am sympathetic with that view to a certain extent,

is that it's very diagnostic, but there's no prescriptions offered. So, all right, you make mistakes. So what? So now what? What do we do? I would argue there are prescriptions. Yeah, I would say the biggest prescription is just knowing yourself and embracing it with both hands.

I know that my risk tolerance is lower than most traditional models would put out. So rather than saying, you know, trying to change my behavior or trying to look at more data to get me more optimistic, I'm just going to embrace that this is who I am and it's fine. You have the ability to do so. But I think that's the prescription is knowing yourself and embracing it. But how is the average investor supposed to know themselves? Well, through the help of an advisor, hopefully. So there's that, but there's also, we know people tend to be overly optimistic about their skills.

The whole move towards indexing and moving away from active towards low-cost passive is effectively admitting, not only can't you pick stocks, but I'm so bad at the process of managing that, I'm just going to throw it into an index and forget about it. That is purely a behavioral decision-making. I guess my thing is that I'm pessimistic on the idea that humans will no longer be human. No, that's always going to be the case, particularly in aggregate. There's always going to be one making the same mistakes. But if there is a way that an individual can get better, and I'm not that optimistic about this because it's very difficult. It's just looking at how you've behaved in the past and realizing that that is a very good proxy for how you're likely

going to behave in the future, that you're probably not going to fix your mistakes, that if you panicked in 99 or if you were greedy in 99 and you panicked in 2008, you're probably going to do that again in the future. And just embrace that. Well, and also people have different objections and different definitions of mistakes. One person's mistake, if you think that you're going to buy and hold, one person's mistake is selling and another person's mistake is not selling. If they're like actively trading, they held on on too long they didn't sell early enough i'm sure there are a lot of people

right now who sold in 2008 who even today would say so glad so glad i did that got out you know got out they just you can make up a narrative of why something worked out well that's the classic hindsight bias where people claim to have seen things coming that they didn't see. All the choices that are obvious in hindsight, we have a tendency to internalize. And suddenly, how many people really saw the financial crisis coming? You count it on one hand, and now you go back 10 years later and ask people, what did you see coming in 06, 07? Half the people are going to say, well, I knew derivatives were a problem. I knew housing was overvalued. I knew the subprime was a disaster. That's just classic hindsight bias.

And I think beyond hindsight bias, the number of people who saw the financial crisis coming at all is small. The number of people who saw it coming and got it right for the right reason is even smaller. And the number of people who saw it coming for the right reason and knew what the subsequent outcome was going to be, like how to play the financial crisis, I think that rounds to zero. Or pretty close to it. You had John Paulson, one of the few people. No, that's the perfect example. Paulson's returns after the financial crisis were horrendous. So he saw it coming for the right reason. Well, it was actually Pellegrini, his researcher, who saw it coming.

But then what to do with it, which was just as important. How to express that in the trade. So if you look at Paulson's aggregate return over a longer period of time, people just focus on how much money he made in 07, 08. He's a net money loser across his career. On a dollar-weighted basis. Because he was $20 billion actually at the peak. No, he was $5 or $6 billion through the crisis.

So he made $2 or $3 billion. Then he scaled up to $ 48 billion and proceeded to lose I don't know 30 40 percent of it not only that but he was a year or two early and betting on the housing market Which is totally understandable. It's not criticism, but he was having to pay money out on those contracts, right? So if you look at the net returns of the from the two years He was early on the contracts and then he made a huge gain and then he played it terribly afterwards The net return is not nearly as impressive as it would be. But isn't that the story of all most successful investors?

Yes, but that's the whole point of what hindsight bias does and putting in effort into your outperformances. It's just a very difficult thing. And even the people who we lionize, if you really look at the full track record of what they've done, it's usually less impressive. This is true for Buffett as well. The last 15 years? The last 25 years. And what's interesting about Buffett is that he really became famous at the moment his returns started to stink. He was back in the 70s and 80s when he was just

crushing it. He was still a relative nobody. And even in the 90s, he was well known among professional investors. But it wasn't until the mid-2000s that every guy in the street knows who Warren Buffett is and what he's done. And that was a period in which he hasn't really... When was the last time that Buffett consistently bought companies or picked stocks that generated outperformance against the benchmark? Right in the middle of the crisis. No, I think it's been 25 years. No, he bought Goldman Sachs. He did a bunch of stuff in 2009. Those did not lead to outperformance.

But to your point of gobbling up companies and generating alpha, it's been a while. It's been a long time. And of course, his overall track record is still great because he did so well back then. So you're saying Buffett should have bought an index fund. What about Bill Miller? He beats the S&P for 15 years in a row, ending in 08, 09, years in a row, ending in 08, 09, goes from top 1% to bottom 1%. And then he had this washout. This year, his fund is up 70%. He's the best performing hedge fund in the world. I don't know if this is exactly right, but I think the last five years have been incredible. Yeah, he's done well.

So he had a great period where he got famous, and he had a washout where people wrote him off, and now he's doing great again. Amazing. But that gets to another point of the consistency of performance. It does not exist for anyone anywhere except for Renaissance Technologies, maybe the lone exception, but even the great investors. There's a study put out a couple years ago. I forget who did it.

Vanguard did this. It was like over a 40-year period, these funds have done very well, not just for a slim period, but their 40-year track record is great. And even those funds underperformed like half the time. And who's going to stick with it? You figure, ah, these guys are done, we're out. So there was a 20-year study and 14% outperformed. And of those 14%, 72% underperformed for three straight years. Yes. And those are when you have a washout. Right. Nobody's sticking with three straight years of underperformance. No. And I also don't think you can blame investors for walking away after a three-year dud because investors, you can claim they're being short-term.

Like, oh, you're just wandering away at the bottom, selling at the bottom, the behavior gap, the worst timing. Sure. But if you are an investor putting your money with a professional manager, what you're trying to do is size up that manager and see whether they have the requisite skills to outperform the market.

And a three-year, it's very difficult in real time without hindsight to know whether a three-year outperformance signifies that that manager has lost its skill or they're just going through a rough patch. It's so easy to point fingers at other people and look at their mistakes. But I think Jason said, Jason Zweig said, like behavior finance is really more of a mirror instead of a window into other people's behavior. It's so easy to point to be like, ah, that person's in it. They shouldn't have done that. But we're all guilty of making these mistakes.

I think that's the biggest point. Or another point to that. I've written articles before that I thought made a good point. I thought they were good. And someone else would point out and say, Maureen, you wrote this article a year ago that argues the exact opposite thing. And I thought that article made a decent point as well. So I think the contradictory nature of a lot of this stuff too

just makes it a really difficult problem. All right, I think that's a good place to leave it. Thank you so much, Morgan, for coming on. Let us know some of your most common mistakes in the comment section below. Thank you so much for watching, and we'll see you next time.