We Study Billionaires - The Investor’s Podcast Network - TIP554: Mental Models for Successful Investing w/ John Jennings

Starting point is 00:00:00 You're listening to TIP. On today's episode, I'm joined by John Jennings. John is the president and chief strategist of St. Louis Trust and Family Office, which has over $12 billion in assets under management. I brought John onto the show to chat about his new book, The Uncertainty Solution. In this episode, we cover why humans are hardwired to shy away from uncertainty, mental models we can use to invest more intelligently, why we're hardwired to quickly come to conclusions and tend to confuse correlation with causation,

Starting point is 00:00:32 how the improbable is much more probable than we might expect, why the economy is not directly correlated with the stock market, where investing falls on Michael Mobison's skill versus luck continuum, and much more. John brings a wealth of knowledge to this conversation, as he is very experienced in the investment industry. Without further delay, I hope you enjoy today's episode with John Jennings. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to the Investors Podcast. I'm your host, Clay Fink. Today I'm joined by John Jennings,

Starting point is 00:01:25 who is the author of this wonderful new book called The Uncertainty Solution. John, thanks a lot for joining me and congrats on the new book. Great, thanks. I'm super excited to be on your show. I've been a longtime fan of we studied billionaires. Well, it's a pleasure to have you on. I just finished reading the book, and I just wanted to jump right into this interview

Starting point is 00:01:45 and dive into some of the lessons I learned from this book. And one of the profound insights I discovered from reading your book was the reality that humans are just incredibly uncomfortable with uncertainty. Can you share with the audience why we're hardwired in this way of wanting nothing to deal with uncertainty at all and how this hardwiring potentially affects our behavior as investors. I've been fascinated with uncertainty in how I personally and then humans in general deal with uncertainty for a long time.

Starting point is 00:02:16 In fact, I thought the book I was going to write was going to be completely about uncertainty. So even though the title is the uncertainty solution and it's a theme that runs throughout the book, you know, really the book, and I'm sure we'll get into this, is more about investment mental models. What's fascinating is that uncertainty or our quest for certainty to resolve uncertainty is what's known as a primary human motive. So we may not even understand that a lot of our actions and what we do, you know, really an underpending is the fact that we don't like uncertainty. And it makes sense from an evolutionary standpoint. So if you think back, you know, if you were a human living in 10 or 100,000 years ago, your ability to recognize patterns,

Starting point is 00:02:58 gave you a survival advantage because if you recognize a pattern and then the pattern persists, it allows you to see into the future, which is a huge survival advantage. So if you can recognize the patterns of, let's say, you know, migration of prey or, you know, weather patterns or or those berries or mushrooms, are they nutritious or are they poisonous? I mean, all sorts of patterns gives you a survival advantage. So the way we've evolved is that when we can see a pattern, we feel good about things and when we can't recognize a pattern, which is really the very definition of uncertainty, we become antsy, we become anxious, we worry. It actually, in some instances, can trigger actually our fight or flight response. So there's things that we do in response to

Starting point is 00:03:40 uncertainty that we may not even realize are going on. And then once we resolve uncertainty, everything reverses. Instead of the fight or flight response, our parasympathetic nervous system kicks in. It's the relaxation response. We calm down. And importantly, we get a little dose of dopamine, which is pleasurable. It feels good. So really our relationship with uncertainty is not just straightforward like, oh, we always dislike uncertainty. We actually like a bit because we love how it feels when we resolve it. So that's why, you know, often we'll not want to know the ending of a novel or a movie. It's why some people like to gamble. It's because they, crave the, let's create some non-threatening uncertainty and let's ride that, you know, kind of wave

Starting point is 00:04:27 of adrenaline and stress and then feel fantastic when it's resolved. And you tell this sort of a case study where people will turn over rocks and sometimes they'll get shocks, sometimes they won't. And it ties into the idea of humans not liking uncertainty where those who experienced the most stress were those who couldn't recognize that pattern that you're referencing. And if I were to tie that into my own life, I think about the example of like going to a doctor and going to a dentist. Like if I go to a doctor to get a flu shot, I know that sharp pain is coming in my arm. But, you know, I'm expecting it. I recognize the pattern. I know it's coming. But if I go to the dentist and it's like, okay, I don't know if this is really going to hurt or not.

Starting point is 00:05:08 I don't know which tooth is going to hurt on. And it's almost like psychologically agonizing that uncertainty that you mentioned and you discuss in your book. Yeah, absolutely. And that study is pretty interesting. And really what it found is, you know, as the study volunteers and how fun did like shock people. So this was a video game they played. And if they turned over a virtual rock and there was a virtual snake, they got shocked. So they played around with could they see a pattern to avoid the shocks? Could they see no pattern? So they got shocked about 50% of the time randomly. And then there was a pattern, which was they're just going to be shocked every time. And that was actually a stress situation similar to being able to avoid. the shock. So it went like this. Pattern, no pain, low stress. No pattern, 50% pain, high stress. Pattern, 100% pain, low stress. So pretty interesting stuff. And if you, to your point, exactly, if you think about it, like, if you knew you were going to be shocked, you would just steal yourself against it. But if you didn't know, so like my parents have horses and they have like this, you know, like electric fence. So it's really, you know, just like, it's just like a wire going around

Starting point is 00:06:13 acres, right? And, you know, I remember once, like, a decade ago, my dad was like, I don't know if the fence is on. Will you touch it and see if it's on? And again, it would be like a pretty big shock. And I was like, no, there's absolutely no way I'm going to touch this fence because I don't know, right? And he kind of goaded me into it and made me feel wimpy. So I did. And it wasn't on. But I remember just like just the adrenaline rush. I can still feel it, just thinking about, am I going to get shocked or not? Just the uncertainty was just terrifying. Your book lays out many mental models, as you mentioned, which we're going to be discussing during this episode, Charlie Munger is practically famous for stating that his key to success in investing in life is his ability to develop

Starting point is 00:06:54 a lattice work of mental models. To open up this piece of the discussion, maybe we could start by just simply defining what a mental model is and explain why having a lattice work, as Munger describes, is helpful. Yeah, so he talked about this, you know, the first record I could find of it was back in 1994 to a speech to the USC business school. And really what a mental model is is it's just a model we keep in our heads, but it's how the world really works in particular instances. And, you know, in reading about quite a bit in books on mental models, you know, what you come to realize is we all have mental models on our heads. But unless you spend time and effort to put correct ones in, you can have things that aren't true. Or you, you know, will jump to

Starting point is 00:07:36 things just emotion and make bad decisions without having the appropriate mental models. And it takes study, right? So it's not like, oh, I can just read of something once and there it is. But, you know, one that I love, and this is one that Charlie Munger has mentioned is Hanlon's razor. So this is a great example. And, you know, if you've ever sent an email and not gotten a response, you often feel a little irritated or maybe even hurt, maybe even angry.

Starting point is 00:07:59 But that's a great time to apply what's known as Hanlon's razor, which is never attribute malice to that which can adequately be explained by stupidity or, you know, carelessness, sloth, this organization, what have you. And the theory behind this is, you. And the theory behind this is that humans don't really have, for the most part, malice in their hearts towards other people. You know, if you don't get an email returned or you get ghosted for a lunch meeting or your brother forget your birthday or cut off in traffic, what have you. I think it's great to apply this and go, you know, I'm just going to give this person, you know, the benefit of the doubt. So that's an example of a mental model.

Starting point is 00:08:33 And since I learned of this mental model probably 15 years ago, I use it all the time. And it really, you know, saves my own emotions. it's saved relationships. I hope people use it with me. I'm not actually that great of an email responder. So that's an example of a mental model. And what I found as I was researching, you know, how to become a better investor, really to help me and my colleagues become better advisors and then to help our clients be better consumers

Starting point is 00:08:57 of investment advice, I found that really what great investors do is they have a lattice work of mental models. They have these things that they fall back on that are true and they know which ones to pull out win. And I know a few weeks ago on your podcast, you guys had Howard Marks on the show. And he's an example of someone, you know, with his memos and his books and just like, you just hear him. And he has these mental models that he falls back on. And like, for instance, I heard him at a conference back in October of 2022. And people were asking him like, what's your opinion of the future? And he was like, this is such a great mental model. He's like, okay, you can't really predict the future. And those that

Starting point is 00:09:33 predict the future don't do a very good job. But that doesn't mean you can't have an opinion. It just, it means that when you have an opinion, you should realize with humility that you're probably not right and wait that accordingly. He goes, so with that, I'm going to tell you what I think is coming. And I realize that there's probably a less than 50, 50 chance I'm correct. And at Oak Tree, when we invest, we have opinions, but we also build in other scenarios and other things that could happen. And we don't go all in.

Starting point is 00:10:02 And like, wow, that is really a great way to think about it. Like, you can have an opinion, but don't go all in. Now, given that we have these issues with uncertainty and we have these mental models we can apply, what are some of the best ways we can deal with uncertainty when our instincts are maybe at times even almost forcing us to do something that might be really silly? Yeah, I think the first step and probably the most important thing is to learn to recognize when you're feeling uncertain and that you are really, you know, flailing around looking for certainty. Because again, it's something that most people aren't aware of. And even, you know,

Starting point is 00:10:44 whether you're aware of it or not, this quest for certainty is going to drive so much of your behavior, even if you don't realize it. So if you can just like turn the light on to the fact that you're feeling uncertain and then just own it. So, you know, what I say to myself is so I have this like alternate name, you know, for takeout and just because I didn't feel like John totally captures my the essence of who I am. So this alternate name of Kiefer. And so what I do is I say to myself, when I'm feeling uncertain, I say, you know, Kifer, you are feeling uncertain. And that's the first and the key step. Like if you can do that, like you're most of the way there. And then to recognize, hear the things that people usually do when they're feeling uncertain. And then what

Starting point is 00:11:29 should I be doing instead? It reminds me of when there's stock market volatility, people will do something they think is good because it gives them more of a certain outcome. For example, maybe they sell after, you know, a stock market drawdown. They just, you know, they're tired of the uncertainty of what sort of volatility is going to come in the future. And they just want the certainty of being in cash, no more volatility. And they think it, it feels good to do that. And they think they're making the right decision, but they're actually making a poor decision because they're acting based on their, you know, primal emotions. Exactly. That is spot on. Yeah, and what we usually do when faced with uncertainty, there's a lot of different things,

Starting point is 00:12:09 but there's four big ones. And the first one is we have this, what's known as the need for cognitive closure. So when we feel uncertain, what we do is we become hypervigilant, we look for answers. And what we want is we want an explanation. We want the world to make sense. So we tend to do what's known as seizing and freezing. So we seize on the first explanation that hits our worldview. And then we freeze on it. So we don't want to, we don't want to revisit that uncertainty in the future. So we defend it. So you have the

Starting point is 00:12:42 situation of, you know, you have this probably not super well thought out or researched response of seizing an explanation. And then we freeze on it. Like that's it. And, you know, I think COVID, you know, the pandemic was this great example of that for so many people, myself included, which is we didn't know what was happening. So we would seize on explanations for what was happening. And then we would seize on explanations for what was happening. And then we would stick with it, even if the science had changed or the virus had changed. And so we tend to, you know, grasp these explanations and, you know, don't tend to change our minds or our worldview. So that's the seizing and then the freezing. Another thing we do is we become information junkies. And I've done this when there's economic uncertainty. I definitely did this in COVID. And when COVID-19 was first

Starting point is 00:13:26 flying out is we also get a hit of dopamine when we take in information. And when things are uncertain and what we want to do is we want to fight answers. And especially with the internet and social media and everything, it's more easy than any other time in human history to search for answers and to search for clues. And that can be great. So if you have something that is unknown that can become known, searching for more information is great. But if you have something that's just unknowable, flailing around searching for information isn't productive and can actually be counterproductive. You may think that you've come up with answers when there's no real answer. And a great example of this. And another thing we do when we're faced with uncertainty

Starting point is 00:14:05 is we turn to experts for their predictions of the future. And experts definitely can predict the future in areas like, you know, engineering and medicine and, you know, these other things. But when you have things like the stock market in the economy or even geopolitics, you know, the ability of experts to predict the future is just really, they have a real poor track record. But we find ourselves, you know, in fact, I have to resist it, you know, clicking on these articles where some famous guru is telling us what's going to happen in the future. And again, we feel like we've got a dose of certainty when you have somebody that's a confident expert that tells you what's going to happen in the future. And one of the final things we do is we like to

Starting point is 00:14:45 associate with groups that think like we do. And in doing research for this book, I came across this comment by a sociologist, which I think is spot on and is one of the biggest thing that has shifted my worldview of how people can have such differing views of what the truth or facts or reality is. And that is, the truth is whatever your social group believes it to be. So, you know, whether it's politics or the economy or, you know, religion or all these other things, like, whatever your social group thinks the truth is is, is what you think the truth is. It's like, wow. So when we feel uncertain, that's not a time period where we want to go and, you know, debate or hear from people all these differing points of view from our own. You know, we tend to

Starting point is 00:15:28 installate ourselves in these echo chambers of people that think like we do. So that's what we tend to do when we are feeling uncertain is, you know, season freeze. We seek more information. We listen to experts. We surround ourselves with people who feel like we do. And again, most of those things are either not productive or even counterproductive, just things that we all should be on a look out for what we're doing in the face of uncertainty, which really doesn't bear fruit. The last of the four you mentioned there really hits home for me where people fall into their camp and they fall into the eco chamber, especially with things like social media and falling prey to listening to just specific experts. One of my biggest insights from tuning into William Green's episodes here

Starting point is 00:16:10 on the Richer Wiser Happier Show is that, you know, he mentions it time and time again, is that the world is fundamentally uncertain. And when people fall into these camps, they can become extremely overconfident in what they believe in. And they just continually to tune in to this one opinion. And I think it's so empowering to just understand that, you know, there is a possibility that we're wrong. And there's a possibility that maybe the world isn't the way we believe it to be. And we need to position ourselves to account for that uncertainty. And it also ties into that point of Howard Marks earlier that you mentioned. Yeah, exactly. And we get to the point where we surround ourselves with people who think the same and we consume

Starting point is 00:16:48 the same media and the same social media. And it seems like it's not possible that other people think something different. That ties into the next question I wanted to ask you, which is related to people quickly coming to conclusions because, you know, they just see this simple piece of data. They're like, of course, then if this happens, then this is going to happen after that. And you caution in your book that correlation does not necessarily equal causation and that the world is a complex adaptive system with many different variables that really can't be analyzed in isolation. And you tell this different example. your book of a child's academic achievement, how that turns out in the number of books that the

Starting point is 00:17:29 child's parents owns in the household. And it makes sense that, you know, a child, if they're surrounded by parents that have a lot of books, then they're probably more likely to, you know, have better academic performance. But that's not the only variable at play. There's people with more books in their household might just generally read more. They might do other things. They might, you know, push for higher education, things like that. Can you expand on this idea that because humans don't like uncertainty, we're prone to quickly jumping to conclusions that are either too simplified or maybe not even true. So yeah, I have an entire chapter of my book called Looking for Causes in All the Wrong Places.

Starting point is 00:18:04 So it's all about causation and correlation and full of stories and examples. And the one you mentioned on books and educational attainment looked at, you know, the number of books in a home and educational outcomes over 27 different countries. And this study was popularized in the book Freakonomics. And it's really the point of what, you know, the Stephen Lerner, Lovett and Stephen Dubner said in Freakonomics as they dug into this was really the answer is that there's this common cause. So, you know, of educational success is the result. The books, having the books in the home didn't cause that.

Starting point is 00:18:38 It was a symptom of the sort of parents that they were, right? Both their genetics and, you know, their view of learning. You know, the type of person that buys a lot of books was correlated with higher educational outcome. their children having a higher educational outcome. So it was like this common cause, right? You know, smart educated people buy more books. Smart educated people tend to have children that go on and achieve a higher educational success. So that was that example there. And there's all these other, there's all these other things with causation. And again, it comes back to our dislike of uncertainty. Like we want the world to make sense and we want to have a cause or an explanation. And sometimes

Starting point is 00:19:18 it's difficult. And, you know, another story I tell the book, which was really quite humbling, is I was at this investment conference, you know, years ago, probably, you know, it's probably five years ago. And you know how these investment conferences go. Like you have all day of like talks and everything and then you have like a cocktail hour and then dinner. So, you know, as I'm sipping my, you know, probably $12 a bottle glass of wine, I was talking to this woman who's the CEO of an investment firm. And it was pretty new. It was only around for three or four years. And I was like, so what does your firm do? And she said, oh, what we do is very simple. We only invest in companies that have strong female leadership. either female CEO or president or females on the board. And it's because, you know, female-led companies outperform male-dominated ones. And it's like, wow, that is amazing. So I instantly was thinking like, that makes total sense, right? Like, and I dug into the research when I got back to work. And, you know, there was all this research that supported the fact that female-led companies outperform.

Starting point is 00:20:14 And it's things like women are more risk adverse. So, you know, their companies won't maybe have the same propensity to blow up. You know, women consumers make 70% of the buying choices. So maybe they're more in tune with their fellow females, you know, more diverse teams outperform. There's, you know, female leadership style stereotypically is more nurturing. And then if you've made it to, you know, president or CEO on the board of directors of a company and you're a female, because of the glass ceiling, you're probably totally a rock star. So maybe these female led companies have stronger leaders because they've had to run this Scotland.

Starting point is 00:20:51 It's like, this is amazing. So, you know, not long after this conference and looking at this research, I was meeting with a client of mine who's one of the smartest people I know. And he led this Fortune 100 company as CEO. And I was telling him about this investment firm. I was like, it's pretty interesting. We're looking into it as an investment. And he's like, yeah, but is there really a causal link?

Starting point is 00:21:09 Like, where is that causal link? Are you sure that there's not like a common cause or like, is this a symptom? So I was like, oh my gosh, maybe he's right. My first reaction was to dig in and defend. But like I have so much respect for them. Like I think if most other people would have questioned me, I'm like, no, no, no, I've researched this. This is good. But I decided to do something that's really hard and battling somebody is known as confirmation bias.

Starting point is 00:21:30 I was like, now I'm going to go try to find studies that disprove this. And I found ones that took the other side. And really to summarize those, it basically said that when you have a company that's doing really well, highly successful company, that they have more resources to spend on things like diversity. And there was this psychologist that had dug into this that said, you know, it's almost like a cynical measure by like companies saying, we're going to recycle our annual reports, you know, or, you know, we're going to, you know, buy carbon credits, you know,

Starting point is 00:22:03 as almost PR that maybe high-performing firms are more likely to hire female leaders and female board members. And there isn't, you know, the jury's still out. hasn't been done so far, at least as of about two years ago when I last researched this. There haven't been longitudinal studies between companies to really tease this out. So I'm not saying that strong female leadership isn't a cause of high performance. In fact, our company, I'm president of our company, but our CEO is a woman who's incredible. And we have 70% female employees here.

Starting point is 00:22:35 So I'm a big fan of female leadership and female led firms. But, you know, the jury is out. And, you know, I had kind of jumped to this causation explanation. and my client's point was a great one. You know, maybe it's a symptom instead of a cause. And, you know, I go through a lot of those things in this,

Starting point is 00:22:51 like that in the chapter, which is really, you know, teasing apart how to, how to look at things and to say, is this just merely correlated instead of caused? You know, is it a common cause? Is it the observation effect?

Starting point is 00:23:04 Understanding that there's often multiple causes, it's hard to pin down, you know, a linear, you know, relationship. Yeah. So I think it's an interesting area and one that's absolutely

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Starting point is 00:27:26 Back to the show. You tell another story in your book of how you were on vacation in another country and you're out for dinner with your wife and you ran into an old friend at a restaurant thinking that how could this happen? This is just so improbable that it practically felt like a miracle to you that fate put you at the same restaurant in this different country and the same city of how big the world is. It just seems like it's totally impossible. But then you make the case in your book that highly improbable scenarios are actually to be expected. So I'd love for you to dive into this and talk about how the improbable can seemingly happen all the time.

Starting point is 00:28:03 Yeah, and it's kind of like this topic is in some respects kind of a bummer, right? Because like we all love a good coincidence. And, you know, it's great to look at a coincidence and think, okay, this shows that there's like this, you know, that there's more meaning to the world, right? Like there's this underlying, you know, ebb and flow that maybe we don't understand as humans and, you know, life does have meaning or what have you. So when I have given talks on this topic, people have been like, wow, that was really a buskill. But yeah, so we were in Paris and we get seated at our table. and, you know, one table over is this, like, fraternity brother mine. I hadn't seen him in years. And his name's Dave. And Dave was like, oh, my gosh, this is crazy. Like, how improbable is this? And one way to look at it is, like, what are the chances? Like, one in the hundred million? Like, this is insane. But really, the way to look at it is not the way that I initially looked at or Dave looked at it, which is, like, wow, the universe is telling us something. You know, maybe we should reconnect and become friends again, right? You know, the fate's saying something. But really, to step back, the way to analyze this. is to say, what are the chances that in all my travels, that I would be see somebody, you know,

Starting point is 00:29:12 whether, you know, in a movie theater or on a bus, in a museum seated next to dinner, that I knew from the thousands of people that I've known during my life. And, you know, it's still a coincidence and it's still fun. But it's not one in a hundred million. It's more like, okay, over the course of decades, it's almost certain that this sort of thing will happen. And there's something, you know, way to think about this. There's something called Littlewood's Law of Miracles. And what this mathematician did is he said, okay, how often do we experience what you would consider a miracle, like me being seated next to a fraternity brother, you know, in a restaurant in Paris? And he said, you know, let's define a miracle as a one in a million occurrence. And then he calculated how

Starting point is 00:29:52 many occurrences do we have a day? And he came up with about a thousand, I guess 30,000 things that you observe and see, you know, during a day. And so if you do, you do, do that and you multiply it by the number of days in a month, you come up with, you're going to hit one of these one in the million things about once a month. And even if you say, well, 30,000 a day is too high, maybe it's, you know, 20,000 or 10,000 or 5,000 a day, you still come up with the fact that, you know, many times a year, you're going to have just absolutely extraordinary coincidences that are just amazing. And, you know, Richard Feynman, who is a Nobel Prize winning physicist and just an all-around entertaining guy, you know, unfortunately, he's not

Starting point is 00:30:32 alive anymore. But he has this book that he wrote, this kind of memoir is called, surely you're joking, Mr. Feynman, which is I highly recommend. Incredibly entertaining. But one thing that he's known to say is, you know, here on the, you know, I'm going to paraphrase, you know, on the way to dinner tonight, I saw something extraordinary, a car with the license plate AEW 357. Isn't that amazing, right? And his point is, is there's nothing special about that license plate. It's just one of the 30,000 things that we see a day. But, you know, if it had somehow been my initials and, you know, my, you know, my year of birth or something, it would have been just like this extraordinary, like, oh my gosh, the universe is

Starting point is 00:31:09 talking to me, you know, occurrence. So really the mental model here is that the highly improbable happens all the time because there's this, you know, just huge tens of thousands of things that happen every month. And if that's the case, we need to train ourselves not to read too much into patterns that we see that really aren't grounded in. anything other than randomness and chance. If I were to tie that into investing, I would say that you want to always account for the improbable scenarios. You know, if you're ever considering doing something like using leverage or concentrating

Starting point is 00:31:44 into one particular asset, you should always account for the fact that no matter how certain you are on this particular strategy, to always, you know, do things like diversify and have excess cash to take into account for those improbable types. scenarios. Yeah, the improbable scenarios happen all the time, and yet we, as humans and its human nature, we seem surprised almost every time it happened. If it's something like being seated next to somebody at a dinner at a foreign city, yeah, that's just kind of fun. But to your point, sometimes these improbable things, you know, really can have an extreme effect on our actual lives, and yet we end up being surprised by them. I think one oversimplified assumption that people make

Starting point is 00:32:26 that you talk about in your book is that if the economy is doing poorly, or if people even think the economy is going to do poorly in the future, then their stocks are going to go down or the stock market isn't going to perform well. But you make this brilliant point that the stock market is not the economy, which might be obvious to some people and maybe a surprise to others. And you share this great Howard Mark's quote that in investing, there is nothing that always works since the environment is always changing. In investors' efforts to respond to the environment, cause it to change further. So why is it that the stock market is not necessarily directly correlated to what's happening in the economy? Yeah. So I think this is probably from a pure straight up investment

Starting point is 00:33:09 standpoint, the most important mental model in the book. And let me just touch a bit deeper on the stock market, it's not the economy, and then we can maybe hit why that is. But really what this says is that what's going on in the economy and what's going on the stock market are uncorrelated. So if you look at current year GDP growth and current year stock market returns, going back to World War II, the correlation's 0.03, so basically zero. And what this means is there's years where the economy is roaring and the stock market is not doing well or even down. And there's years where there's years where there's recessions and the stock market is up. So in fact, looking back to the 1930s of the 19 years where there's actually been negative GDP growth in a year, in other words, during a calendar year, you know, 12 of those 19 years, the stock market was up and most of the time more than 18%. And so you can look at it and go, well, that's bonkers. Like, how is it that you have a contracting economy and a stock market that's up? But what's fascinating and this came out of research I read that came from Credit Suisse.

Starting point is 00:34:07 So I'll just say that name because that name is going away, as we all know, as they're being subsumed by UBS, you know, I think here in the next few months. But really, if you look at the prior year stock market returns and the current year GDP, then the correlation jumps to, you know, kind of a point six and above, meaning that the stock market predicts what the economy is going to do, not perfectly, kind of an ish, right? But the economy doesn't predict what the stock market's going to do. And as an investor, you'd love to have it reversed. You'd love to say because it's easier to kind of figure out, I mean, not, you know, ish what's going on in the economy and say, okay, I'm going to use that to inform my investing. So you could say, oh, you know, I think inflation is a problem and interest rates, Fed raise and interest rates going to slow the economy.

Starting point is 00:34:50 and therefore, you know, we may not tip into recession, but we're definitely going to have slower growth here for a while, right? And then if you could take that and say, now I'm going to use that to kind of time my investments. That would be amazing, right? But that's not how it works. So the stock market moves in advance of the economy, typically up and down and tells you what the economy is going to do, which has some usefulness. But as an investor, it's just not very useful. And so what that means is, is pretty much every economic indicator out there. And so what that means is, is pretty much every economic indicator out there. And so, there doesn't tell you what's going to happen in the stock market. And I've been on a number of charitable investment committees over the years and even chair of some endowments. And we'll have these investment managers or these consultants come in and they'll give us their economic update. And they'll talk about all these things going on in the economy, their views of the path of interest rates and inflation and unemployment claims and GDP growth and corporate earnings and all these things. And then based on that, they'll talk about how they would tweak the portfolio. And what they're missing out there. And I'll talk to some of them and I'll say, you know,

Starting point is 00:35:53 do you do realize that all those things you just listed out don't tell you what's going to happen with stock market returns? And some of them are surprised by this. The more erudite ones go, well, we know. And I'm like, well, then why did you spend, you know, half hour talking about them? But it means that all these economic indicators don't tell you what the stock market's going to do, which is, again, it may seem like depressing and like, oh, well, that's telling us there's no Santa Claus. But knowing that is so important. So like, During COVID, when things were getting really bad, you know, we didn't go to our clients and say, you know, let's take some risk off the table and move out of the market. In fact, if anything,

Starting point is 00:36:28 we rebalanced into stocks, not thinking that we knew when the bottom was, we just knew that all the bad news in the real world and in the economy wasn't going to tell us when the stock market was going to bottom or what the stock market was going to do. So, you know, it was kind of this incredibly short bear market that was very steep and then this great rebound. And I think people that looked at all the bad news, they missed it. They didn't invest their money or they pulled money out. And the bottom was March 23rd of March. And on that day, or like three days later, they announced the thousandth COVID death in America. I mean, imagine. Like if somebody, you know, think about this, Clay, if somebody said, hey, guess what? I have a crystal ball. And here's what I'm going to tell you.

Starting point is 00:37:06 Okay, we just hit a thousand deaths. We're going to have nearly, you know, 350,000 in the U.S. by the end of the year. It's going to hit a million or two million worldwide. International travel is going to shut down and pro sports leagues are going to stop and all these restaurants are going to fail. Entire industries are going to be decimated. You know, GDP growth this quarter is going to be a negative 14 something percent. Unemployment's going to spike to nearly 15 percent. Here in a week or two, we're going to have three million weekly unemployment claims. Like if we knew all that, and oh, by the way, this is going to go on for years.

Starting point is 00:37:36 Like, if we knew all that, like, we would be like, okay, we're taking our money out of the market. But if you use the stock market as not the economy, you know that you can't use. what's going on or even if you knew what was going on the economy, you can't use that to inform what's going on in the stock market. In fact, I wrote an article in Forbes on March 26, three days after the bottom that said even with a recession looming, that doesn't mean you should sell the stock market. And I went through a lot of these things and I had people say, wow, how did you know, how did you call the bottom? And they're missing the point. Like I didn't call the bottom. I had no idea. The point of the article is we have no idea. Could have gotten

Starting point is 00:38:16 and worse? Absolutely. Why was that the bottom? Don't know exactly. So I think that's what's important to know about this middle model. The stock market's not the economy. And if we moved it, like, why is that the case? And that's where we get into this concept of complex adaptive systems. And, you know, this really comes from engineering, but it is applicable to complex social interactions. So this is true of politics. It's true of the economy. It's true of the stock market. And the idea here is that in the economy and in the stock market, you have actors that are intelligence called agents. So these are all the people and all the companies that buy and sell stocks. So they're intelligent.

Starting point is 00:38:56 So they don't operate on rules of physics, you know, like Newtonian physics or even the theory of relativity, right? It's everybody watching each other, watch everybody, watch everybody else. So we're all trying to decide what everybody's doing. And if you think about investing, the true value of a company is what the market says it is, means everybody else. And we learn from patterns. So we have these feedback loops. We have external information. So you can use like, for example, let's use like GameStop. So going back to the meme stock, you know, from early 2021. And, you know, really there was no underlying sound fundamental, like economic reason why GameStop would do well. Really, it was, you know, this chat group on

Starting point is 00:39:37 on Reddit that started driving it up. And so people bought shares a GameStop because they thought other people would buy shares of GameStop. And, you know, it was AMC as well. And, you know, Bedbath and Beyond, which just declared bankruptcy, unfortunately. But then what this did is this caused real world effects. So, like, what AMC did, which was brilliant, is they said, hey, like, if these Reddit people are going to push up the value of our stock, we're going to issue more stock. We're going to gain all this, like, financial, extra financial footing.

Starting point is 00:40:06 So they started issuing shares of stock, which in turn, you know, gave the company more money to write out the problems with movie theaters and everything. So it created these real world effects, which in turn made people go, oh, well, maybe we should buy AMC. It was fascinating that this sort of thing happened. But what it means is with a complex adaptive system,

Starting point is 00:40:25 is you can't take the inputs and know what the outputs are going to be. It's like toilet paper hoarding in the pandemic. Like going to the pandemic, like Clay, if I was like, what do you think if, you know, people are going to hoard some stuff?

Starting point is 00:40:36 What's it going to be? Like, if you're like me, I would probably would have said, jugs of water or cans of beans or, I don't know, something useful. to survival, you know, not toilet paper, but once it happened, individual rational actions,

Starting point is 00:40:49 which is if you see some toilet paper buy it, like don't let that package of toilet paper pass you by because you don't know how long this is going to go on. But that further created this action, this irrational outcome system-wide, which is a toilet paper shortage, which was bonkers. And, you know, I was part of this in April 2020. I was in Walgreens picking up a prescription. And I saw, you know, this mostly empty shelf of toilet paper. And there was one package that. there and I bought it, even though we didn't need it. And I was telling the checkout clerk, I'm so sorry I'm buying this. We have plenty of toilet paper. I'm being part of the problem, not part of the solution. And she was looking at me like, just, I have no idea what you're

Starting point is 00:41:22 talking about. Just check out. So that's really how the stock market and economy work is, you know, all these individual actors that are intelligent in learning and reacting to patterns. And that's why it's so hard to predict, you know, what's going to happen in the stock market or in the economy. And this is why experts get it wrong over and over again, because it's just not something that can be modeled well. And it's why, you know, patterns that have persisted in the stock market in the past won't necessarily work in the future. But it's because, you know, we've learned from the prior patterns. And once a prior pattern is known, then everybody knows it. And you have to have a buyer for every seller and a seller for every buyer, right? So anyway,

Starting point is 00:41:59 I've probably been just getting too excited about these two mental models. I wanted to tap more into the great financial crisis. I didn't personally experience the dot-com bus or the great financial crisis. as an investor myself. So it's always interesting to draw from the experience of others who actually lived through it. And I took this piece from your book that the market bottomed on March 9th, 2009, after a 57% drop. And the trove of the recession in economic growth didn't come until four months later in June. And it just ties directly into, since the economy is not the stock market, you know, just because the economy is going down, the stock market actually rebounded

Starting point is 00:42:40 four months before the economy rebounded. And I'd love for you to tell the story of the hedge fund manager you chatted with during that time. And you chatted with him and he was just screaming more pain to come. And you actually decided not to make any changes to your client's portfolio. So I'd love for you to tell this story. So first of all, let me say that like the great financial crisis, the great recession, wow, like it's one of the really seminal things, you know, experiences I've had in my life that was so stressful. Like I felt, all this responsibility for our client's assets. And I really, you know, I hadn't developed all these mental models and I didn't know what to do. And I was this big consumer of financial information.

Starting point is 00:43:21 Like my amount of knowledge about what's going on in the economy and the markets was greater than it is now. But I, what I was lacking is, you know, kind of the Charlie Munger wisdom and mental models to make good decisions. And so it's really the great financial crisis that was the impetus for me writing this book is all that I've learned. Because I realized after that experience, you know, that I wanted to find, you know, what did great investors do? What do they know that I could learn? That really spurred me on the financial crisis. You know, and what I was doing is trying to find more information about like, I couldn't see how we were going to get out of this. And I know that the entire global financial system almost collapsed. I don't even know what that means. I just know

Starting point is 00:43:59 it's really bad. And I was reading all these economists and investment managers that were just saying, you know, there's no way out and everything's going to get worse. And so I'd gone to a conference the prior year where I had met this hedge fund manager that had given a talk and he was so impressive and their returns were great. And, you know, kind of back in the aughts, you know, hedge funds were kind of the darling investment and money was flowing into him. And this guy was so impressive and had all these pedigree and everything. And I ended up, you know, having an adult beverage with him in the cocktail hour of the investment

Starting point is 00:44:29 conference, a way to exchange cards. So I'll call him Tom, as I do in the book. It's not his real name. But, you know, I ended up emailing him and setting up a time to talk. And, again, it was on the phone, you know, back in the own. 9, we didn't like, you know, Zoom and, you know, Skype. And I asked him, I was like, you know, what do you see happening? What's our way out of this?

Starting point is 00:44:44 And he said, oh, you know, what we've experienced so far is just an appetizer to like this much bigger meal of misery that we're going to, we're going to have. And he said they'd move their hedge fund mostly to cash in gold. And, you know, it's like a $3 billion hedge fund. You know, they'd moved it almost out. And, you know, they were pretty sure that the stock market, which was at this point down, you know, nearly 50% in February of 2009 was going to be down another $50. 50%, you know, the way that math would work. I guess I'd mean like 75, you know, over 75% down

Starting point is 00:45:13 from the high. And he was at the time just so incredibly dower. And he had all these great reasons. And there were things that I'd read before, but to read someone that had actually said, okay, we're, you know, really selling our clients out. And he said he had even bought farmland in New Jersey because he lived in New York City. And he had like this stockpile of gold coins to buy passage out of New York City if, which he thought was a decent. chance if the economy collapsed. He was like, it's going to be like, you know, escape from New York stuff. If you know the old movie, by the way, which was filmed in St. Louis, go figure. But, you know, the old movie escaped from New York. He was just like, I'm going to be able to get by passage out

Starting point is 00:45:52 of New York City. And, you know, maybe gold has always been a store of value for most of civilization. And, you know, they had like guns and generators and seeds and everything. And he was going to like live off the land in like rural New Jersey. And I was like, oh my gosh. Like, I am so upset. And I remember talking to a few of my coworkers. And fortunately, they kind of talked me off the ledge, you know, and I did like breathing exercises and meditated. And they're just like, okay, it's just one opinion. I'm like, yeah, but there's a lot of people with similar opinions. But I think cooler heads prevailed because it really, really freaked me out, you know.

Starting point is 00:46:26 And but I look back on that in addition to me an entertaining story in retrospect. And by the way, what he predicted could have happened. Like, it could have happened. It just didn't. And, you know, later in my book, I talk about something called invisible history. which are things that could have happened but didn't. So I look back not just to be like, you know, and I say something's funny in my book. Like whenever I look, you know, think back on this story, I think about Tom sitting in a cellar in New Jersey, you know, like with a shotgun across his lap, you know, eating a can of peaches, right?

Starting point is 00:46:54 Or something, you know, which I thought was kind of funny. But I really have more sympathy for this, you know, and if you're a hedge fund manager, you know, maybe you're all about making big calls. And he could have been correct. But I use this as a mental model to remember that, you know, even if you have all of the, possible information you can have, you know, this highly pedigreed, you know, hedge fund manager with all this staff and this analyst analysis and research. It doesn't mean that you're going to be any better than anybody else from calling what's going to happen in the stock market. And about a month later is when the market bottomed and his hedge fund. And I haven't gone back and checked it out,

Starting point is 00:47:30 but they may well have gone out of business because they'd moved everybody to cash and gold and missed the, you know, from March 9th, 2009, you know, the end of 2020. even with 2022's down period, stock market's been up over 600%. So, yeah, that was a costly mistake. And just it reminds you that, you know, even though he could have been right, this idea that you need to know what's going to happen in the future and that you should follow expert predictions to invest, it's just a great example of why none of us should invest based on our own or others predictions of the future.

Starting point is 00:48:02 I think this ties well into a point you make from your favorite investment book, which is the success equation by Michael Mobison, who has been on the show back in 2021, I believe. In it, he has what he calls the skill, luck continuum where certain activities fall somewhere on the spectrum of primarily being skill-based or primarily being luck-based. Based on your research and writing this book, where do you think investing falls on this spectrum? Yeah, and of his books, you know, the success equation, and it's really my favorite investment book because it's it's had you know this outsides maybe the biggest impact on how I view the you know the investment world and really open my eyes to a lot of a lot of things and yeah his

Starting point is 00:48:44 skill luck continuum is pretty fun because it's not just investing you know you know you know in one end of the pure luck is you know like roulette and slot machines you can put the lottery there you know just complete luck and at the other end things that are 100% skill like chess is 100% skill and things that are pretty close to full skill which are like races so like a running race like a 100 meter race, running race, or, you know, in swimming. So if you think about it, like Michael Phelps, you know, he's going to be a less skilled competitor pretty much every time. There's very little luck involved.

Starting point is 00:49:15 I guess he could like, you know, slip a little bit coming off the block or have something happen. But really, I guess, you know, even that falls within skill. But you look at a lot of sports. And, you know, they vary in how much, you know, luck is involved. You know, I love, I love hockey. And all the time, you know, you'll watch your team and your team will hit the goalpost a few times you'll lose or you know vice versa happens or you know you're watching football and a you know

Starting point is 00:49:39 the game winning field goal hit doinks off the uprights or there's all sorts of things that happen that you can see where you know luck comes into play but really you know he did all this the study and research and analysis and what he found is investing falls way down towards the luck into the continuum you know skill matters but it it's way you know it's it's it's definitely much more towards gambling, and some gambling like poker, you know, has a lot of skill, but it's much more down towards, you know, the roulette than it is up towards, you know, chess or swim races. And he asked a few great questions that we all can ask to tell where an activity falls in the continuum. And the first is, can an amateur beat a pro? And the answer on skill-based

Starting point is 00:50:23 things is no. Like, I don't play chess. So if I, if I played my nephew who is this incredible chess player, like, I'd have zero chance of beating him. And, And, you know, I swim. And if I swam against Michael Phelps, like, it would be laughable, like, or ran a running race against, like, a college, you know, or even high school, you know, track person, they would just, they would cream me. And, you know, same thing. If I played one in one basketball or horse against, like, a college basketball player. Like, all those things, like, an amateur cannot beat a pro roulette. Whereas if you think about roulette, like, can an amateur roulette player beat a pro roulette player? Yeah, of course. Like, like, it's, it's random, right? And or slot machine. Like, like, can an amateur slot machine player win? And if you think about investing, An amateur can beat a pro all the time. And I tell the story of my book of in 2020, our highest performing portfolio in 2020 was that of a middle schooler. You know, we had helped her set up an account at Schwab and, you know, educating her on stocks and like, oh, what stocks would you like to buy?

Starting point is 00:51:16 You know, I think she had like thousand bucks for grandparents. And, you know, she picked like Netflix and Tesla. It was like some of the highest performing stocks of 2020. So it was like three or four stocks. And, you know, we went back and looked at like, you know, what can we learn about the high versus low performing portfolios? And yeah, so this middle schooler was the top performing. And so it just shows you that an amateur can beat a pro in investing.

Starting point is 00:51:38 And it happens all the time, especially over shorter periods. And then on the other question he asked, which is so good, is can you lose on purpose? So if the outcome is mainly based on skill, you can lose on purpose. So like I could, you know, my nephew in chess could choose to lose to me on purpose. He could intentionally make poor moves. Or if I was swimming against somebody that was a better swimmer, they could choose to swim slower and I would win. I race my now six-year-old nephew and like I'm still faster than he is. So I could choose as I usually do to lose. Every once in a while I choose to win, but mostly I choose to lose, right? And the

Starting point is 00:52:12 same thing is investing true of stocks. Like, can you lose on purpose? And you know, when I ask this question of people that they often say, oh, well, yeah. And that's just though, not really. Because if you could pick stocks in advance that weren't going to do well, you could make a ton of money as a short biased, you know, stock picker, you use short stocks. And they're basically, you know, like no famous short managers because it is so hard to do that in general stocks go up to, so pick the ones that go down or even to pick the ones that are relatively don't do as well as others is incredibly hard to do because, you know, long, short hedge funds, their history and their performance hasn't been been great. So it just really shows you that, you know,

Starting point is 00:52:53 investing, you know, skill does matter. But there's a huge component of luck. And, What this means is, is when you see an investment manager or a middle schooler that does really, really well, you know, it behooves us not to read too much into their performance. Or if they do really poorly, we can't read too much in their performance. I mean, if picking a star investment manager that was going to outperform in the future was merely as simple as how they performed into the past and let's pile into the ones that have done well, that would be easy. But, you know, what studies of public stock managers has shown is there's basically no persistence from year to year to year. And very few investment managers over long periods of time show that they have skill and they deliver outperformance beyond their fees. So there's a lot that have skill, but just not in excess of their fees or especially the taxes that might be generated. So what it means is picking a manager, someone that's going to buy stocks for you that's going to outperform.

Starting point is 00:53:49 You know, picking a manager like that is really hard because there's so much luck involved and it's so hard to tease out skill. I think a key part of that last point with the difficulty of success in investing over long periods of time is that times are continually changing. An investor might have a really good decade, but if they apply that same exact strategy the next decade, then odds are they aren't going to do as well because just times change and the environment changes. Yeah, that is so true. It's really hard. And what happens is, as an investment manager, there's ways to invest that you have a high likelihood. that you're going to beat the market. But the problem with them is that it takes a lot of time for you to be correct. And there'll be a lot of time where you look horrible. And in fact,

Starting point is 00:54:36 Vanguard did a study of investment managers that had over 15-year period that both survived and then beat the market. And of the over 1,500 funds they looked at, you know, only 18% actually beat the market over the 15-year period. And that's pretty consistent with other studies by S&P and others that have looked at, you know, the success of active managers. But what was fascinating, of the 18%, two-thirds had five or more years of underperformance. So five years out of 15 years, if I do my math correctly, is one-third. And a lot of them had six, seven, eight years of underperformance. And also the majority of them had at least three years of consecutive underperformance.

Starting point is 00:55:22 And so what that means in the real world is if you're an investment manager and you're like, okay, I'm going to outperform, but I know that I'm going to look like crap, like a lot of the time. The problem is your investors likely won't be sticky. And that after three years of consecutive underperformance or four or five even, or, you know, I'm underperforming five or six or seven out of 15 years, you know, you'll have people fire you and you will go out of business. So what the investment managers do is they change their strategy so they don't get fired or they invest in a way that is very similar to what the market is, and they just tweak it a bit so they don't look too different. And it's really a business decision, and it's really based on, it's really based on the investor.

Starting point is 00:56:04 It's really the investors, you know. And there's this idea that if you could invest maybe with a manager that has a lockup. So imagine if you invested with an investment manager that said, I'm going to buy publicly traded stocks, but you can't get out for 10 years. Or you could invest in a publicly traded manager that you can get out every day. I'll tell you that the one that you can't get out of for 10 years, likely with a high degree of likelihood will beat the one that you can get out of every day because the one that's investing for 10 years is going to invest with a long-term view and not be worried about whether their

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Starting point is 01:00:07 Back to the show. You also touch on some behavioral biases in your book that are, again, hardwired into us, which essentially means we're all susceptible to these to some degree. And two very common behavioral biases are loss aversion and overconfidence. And part of me feels like these kind of go at odds with each other. If you're loss averse, then you might not take enough risk. If you're overconfident, you might take too much risk. So I'm curious if you believe that most people are susceptible to both of these to some degree,

Starting point is 01:00:37 or do people sort of lean one way or the other that they should be aware of? Yeah, I don't really think that they're actually at odds. I think there are things that each of us applies at different times. And I'll give you an example. So if you're overconfident, so it means that you think you know more than you do, you're better than you are, you're better looking than you really are. You're a better driver than you are, you know, better spouse, parent, you know, on down the line. But in terms of investing, again, it means that we think that we know,

Starting point is 01:01:07 more than we do or that other people do that we make better decisions. And then we have this loss aversion, which, you know, at its core states that losses feel more painful than gains feel good. And so there's these different things that we do when we're faced with decisions with loss aversion. You know, the first is, is we make decisions to avoid losses. But then importantly, once we're at a loss, we tend to double down. Like, we don't want to keep, you know, we don't want to lock in the loss. and I think overconfidence there goes hand in hand because, you know, when you're down and you decide, okay, I'm going to double down or I'm going to engage in risk seeking behavior because I don't want to lock in a loss. It just shows right there that you're being overconfident in terms of your abilities.

Starting point is 01:01:51 And really, you should step back and go, okay, this investment that I have is down. It's at a loss. What should that teach me about my ability to make investment decisions? You know, if it's just the rest of the market's down, fine. But if it's down, you know, more if it's an individual stock or other type of investment, maybe you should say to yourself, I don't really know what I'm doing. I'm going to cut my losses instead of, you know, engage in risk-seeking behavior. But I do, to your point at the beginning of the question, I do think that these are two of the biggest behavioral biases to be

Starting point is 01:02:21 aware of as investors. And I hit five of them in that chapter. And, you know, there's entire books and great ones written about behavioral biases. And I think a key takeaway is, and, you know, my business partner, Spencer Burke, who also my mentor, you know, what he has said over the decades is, you know, you read these books about behavioral biases and a few things happens. First of all, it's human nature because we're overconfident that we think about like, oh, other people do these. Like, oh, these other silly people that, you know, are doing risk seeking behavior when they're at a loss or these silly people that have hindsight bias or succumb to confirmation bias, etc., etc. So we first of all think that we're not as bad as everybody else.

Starting point is 01:03:01 And so we need to be like, no, we're as bad. I'm human just like everybody else. But then the other thing that's sort of insidious is once you read about these biases, you think that now that you know them, that you're going to be better at them. And what I've found is so, you know, like I have this professional certificate where a lot of studying research, it wasn't actually, you know, like a multi-year sort of thing. So maybe it sounds more impressive than it is. But, you know, in prep for that, but also over the years, I've probably read, I don't know,

Starting point is 01:03:27 15 books on behavioral biases and behavioral aspects of investing in the like. And every time I read about it, I think, oh, okay, I got this, you know, I got this. I'm going to be better. And I'll tell you, I think I've gotten a bit better just because I've done so much study over the years. But this, I think this idea that you can read, you know, like one book or one paper or like my book, one chapter. And like, okay, you've got this, you know, you're going to make this big improvement, you know, to realize that these are hardwired into us. And, you know, a thing I hit in my book is some of the reasons why that is. And I think, you know, behavioral economics or behavioral finance or whatever you want to call it,

Starting point is 01:04:06 tend to talk about these biases and then heuristics, which means, you know, this shortcut that you make, these shortcuts you make in decision making. You know, they talk about them, like, in this way, like, aren't we flawed? You know, most of the books. But really, if you dig into, like, evolutionary psychology, you know, there's really good reasons why we have these biases. and it's because having these biases helped in terms of our survival. So we've evolved to have them.

Starting point is 01:04:31 But the situation we are in now is that we have these ancient brains that evolved to be in this time period of thousands or hundreds of thousands of years ago. But we live in modern times where we're not being stalked by prey and we have all this abundance. and, you know, we feel these, you know, these biases come into play on our decision making when so many of them just aren't as applicable anymore. And that's really our struggle. Because if you think about, like, loss aversion, those ancestors of ours that took action not to lose are the ones that were more likely to survive. Because, you know, back in the day, we'll call it like the caveman days.

Starting point is 01:05:14 a mistake could easily lead to your death or at least your inability to reproduce and, you know, pass your genes down. And it was the ones that were more risk adverse in an incredibly treacherous world that survived and passed on their genes and we are their descendants, right? So there's a very good reason for us to be loss adverse. But again, as an investor, for most people, it just doesn't make sense to give outsized, focused in emotion to losses as compared to gains in this world of abundance that we live in. And another behavioral bias that I really enjoyed learning more about was how we're just

Starting point is 01:05:53 naturally drawn to a really good story. And with a lot of investments, people have almost perfected the art of telling a good story around it to almost pitch it. So what should we know about storytelling to help prevent us from being persuaded into a position? potentially poor investment. So this is something that isn't talked about a whole lot when it comes to investment behavioral biases. And it a bit falls under the, you know, what's more commonly known as like base rate neglect. I just think calling it storytelling bias adds a different, you know, spin to it that is,

Starting point is 01:06:28 first of all, sounds more interesting than base rate neglect. But it also, you know, flips it and highlights why we neglect base rates. And so storytelling bias, you know, it's interesting. I read this book called Tell Me a Story. this AI pioneer named Roger Schenck. And he wrote a book, this book, Tell Me a Story in 1995. So if you think it back to 1995 and compared to what's going on with AI today, you know, like in 1995, we had had, you know, I think the, you know, definitely the first, maybe the second Terminator movie and some science fiction, but, you know, really hadn't done much in the way of artificial

Starting point is 01:06:59 intelligence. But what he says in this book, which is fascinating, is one of the big challenges with AI, an AI passing what's known as the Turing Test. And the Turing Test was something formulated by Alan Turing. So, you know, he was famous in the 40s as one of the big code breakers in Britain and the, you know, Enigma Machine and is arguably the creator conceptually of, you know, modern day computers. But he had created this test of will there be a time period someday? How can a computer trick a human to think that they're interacting with another human, right? So that's passing the touring test. And there's like movies like like X, Machina, which is just a great movie about this sort of thing. So, you know, Roger Shank was writing one of the big challenges,

Starting point is 01:07:39 or maybe the big challenge with AI passing the touring test is that the way that humans interact is we tell each other's story. So I'll tell you a story of something that's happened and you'll tell me one back. And your story back will typically be relevant to my story. And what that story will do will convey to me that you've heard me and you understand. And then I'll tell you one back and we'll go back and forth. In fact, we judge each other's intelligence by the quality of stories that we tell. So like if you go out and you meet a person or if you're somebody that's dating and you go on a date

Starting point is 01:08:09 and then afterwards someone says, oh, you know, how intelligent was Carl. You won't realize it, but the way that you will evaluate Carl's intelligence is what quality of stories did Carl tell me? How relevant were they to mine, et cetera? And the reason we evolved to be storytellers is because, again, it comes back to a survival advantage, everything else evolutionary. And there are other mammals or animals that work in small groups, but humans are the only species that works in a large-scale group. So, you know, there's something called Dunbar's

Starting point is 01:08:42 number that you can really only know 150 people or know, you know, know them by name and by parents and know something about them, right? But if you think about it, we have all these groups that are much bigger. You can work for a company. You know, I used to work for Arthur Anderson. We had 88,000 employees. And I identified as an Arthur Anderson employee. And there were certain stories about how we served clients and what we did or, you know, nations. Like, there's certain narratives and stories around, you know, being an American or, you know, being a Brit, a Canadian, et cetera, et cetera, and religions as well. You know, there's certain stories that different religions have, you know, about creation and what the religion stands for and et cetera, et cetera.

Starting point is 01:09:19 So we can believe as a species, all these things. And what that allows us to do is it allows us to work in bigger groups and to have shared myths and shared experiences. And so because of all this, we pay outsized attention to stories. And what this means from an investment, perspective and just making decisions in everyday life is that we rarely stop to consider the base rate of, you know, what's happening. So, you know, I'll give you an example. Yeah, go ahead. Could you just briefly define what a base rate is? I feel like this is a topic that isn't discussed too often. I first learned it from Buffett and I think it's just an incredible insight. So please define what a base rate really is. Really, it comes down to statistics like what is the probability of something

Starting point is 01:10:04 happen in a given situation. So, for instance, you know, we needed to send my daughter's passport to her. So she's, my younger daughter's off at school and is applying to study abroad. And we were discussing, you know, should we wait till she came home for spring break or should we like UPS or FedEx at her? And it was interesting. My wife made a good point. She said, you know, I read the story that popped up on, you know, social media of somebody that was FedExing something really. important. I forget now what it was and how it got lost. And like, it was something that was basically, you know, irreplaceable.

Starting point is 01:10:40 And so I don't think we should FedEx the passport. If it got lost, this would be horrible. And, you know, I ended up agreeing with her. I said, yeah, the risk is too high. Like, if the passport gets lost, like, she may not be able to get a replacement in time and to get a visa and to study abroad. So we decided to wait until she came home a few weeks later, you know, which had a negative effect on the timeline. But really another way of thinking about it is we could have research, what's the base rate? Like how many FedEx envelopes go missing? And we could have weighed

Starting point is 01:11:08 this one story that we heard of this person on social media that had something irreplaceable lost by FedEx. We could have weighed that against the, you know, the point zero zero zero one percent. I haven't looked it up. So I don't know what it is. Chance of it would have been lost. But neither of us did that. It was only later, you know, that I was actually thinking about, oh, we didn't apply, you know, the base rate. And other base rates are things like the vast majority of startup businesses fail. Like, less than 30% of it make it to their 10th anniversary. Or the majority of stocks, publicly traded stocks, underperform the market.

Starting point is 01:11:41 So over any given year, any given 10 or 20 year time period, two thirds, three, fours, even than 80% of stocks underperform the market. So, like, you would use that base rate to inform, should I be buying a single individual stock or even five, knowing that the chances are that most, if not all the stocks I will pick, will underperform the market over the next 10 or 20 years. So it behooves us as investors to think of the base rate. But the problem we run into is because we're primed to pay attention to stories. First of all, we hear stories of other investors making outsized returns.

Starting point is 01:12:16 Our friends typically talk to us if they're going to talk about investment, about their investment victories, et cetera, et cetera. But also we're being sold stories. We're being told stories. even if you're just looking at investing in a single stock, the company has a story to tell as part of their marketing. They may not necessarily be trying to sway investors, but they're putting forth. Like, you know, just think about like Facebook, which is now, you know, meta platforms kind of based on the whole metaverse concept. Like, they're putting out the story of what they see the future being and how they're going to take advantage of that. And so if you said,

Starting point is 01:12:48 I'm going to spend any time at all reading about whether I should buy meta stock, you're going to get the story about the future. that they're going to be selling you. And we hit this as investors all the time. And in my book, I think the most fascinating study on this that I've read was one of medical decision making where basically they told these volunteers, you have a fictitious disease and there's two different drugs. One has a 50% effectiveness rate and then the other one they would vary.

Starting point is 01:13:14 And the other one, let's say it has a 90% effectiveness rate. So they'd be like this. Clay, you have a disease. It will kill you left untreated. Drug A has a 50% effective rate. Drug B has a 90% effective rate. But then they tell you two stories. about the 50% drug, they would tell you a neutral story.

Starting point is 01:13:28 Chris has taken the drug. We don't know if it's going to work. The second drug, Pat has taken the drug. It's not working. She's blind and can no longer walk and her death is imminent. All right. So based on that, most people in this situation picked the 50% effective drug instead of the 90% effective. Like the 90% effective drug is, you know, based on clinical trials and FDA approval and all this, blah, blah, blah, blah.

Starting point is 01:13:49 But one story swayed most people to pick the less effective drug, because there was a negative story attached. And when they said this drug B is 30% effective and told a positive story, you know, like 80% of people still pick the less effective drug because the positive story was attached. So it's not even just an investment concept. And what I think is fascinating and as I've dug into, you know, the storytelling bias is pay attention. I say this to all the listeners, pay attention to how when you interact with people, you tell

Starting point is 01:14:16 each other stories. And then when you go to make a decision, how you're almost certain to pull out a single story that you heard, you know, a new story, something you heard on social media, something you heard from a friend to inform your decision. And you probably won't go research what the base rate is, which is, you know, how often what really happens in the real world and how that should affect your decision. And I'll tell you, like, I do it too. I've become expert on the storytelling bias. And I laugh at myself how often I succumb to it like I did with the, you know, the FedEx story that I just told. So again, like, I feel good with our decision because we couldn't take the

Starting point is 01:14:51 risk of not FedExing the passport, but I didn't stop to consider the base rate. I jumped into the story. It was like, oh, I don't want that to happen. Great story, honey. It's really hard. Yeah, I mean, I think the case of the IPOs is a perfect example where an IPO might have a great story and it might make a ton of sense to you. But if you invest, you should keep in mind that the base rate is really low for the success of IPOs. And then there's all these incentives for, you know, the investment managers trying to pitch it and the company wanting to to get a lot of attention, but I don't want to hold you too long. And I wanted to ask you a couple questions since you're in the wealth management industry. We've had a number of guests on the show

Starting point is 01:15:31 that have claimed what I'll call the death of the 60, 40 portfolio now that inflation is here to stay. And there's all these reasons for why it structurally may be around for the years to come. I just wanted to ask if you have adjusted your portfolio or your client's portfolios to account for a potential inflationary environment or regime, if at all? Yeah, so again, a little bit about our company. So we're a multifamily office. We oversee help our clients with about $15 billion of wealth. And about, again, about 63 client families we work with. So that's a bit about what we do. And, you know, we don't really have, you know, here's our exact model portfolio. We should do for clients. It's pretty custom and based on what they need in terms of cash flow and things.

Starting point is 01:16:15 But that being said, we don't have many portfolios that are 60, 40. You know, we don't have. We tend to be the kind of eight, more like the 80, 20, 20, 30, sometimes 90, 10, sometimes 95, five. It just really depends on the client. But as we've dug into inflation, which we've done, you know, numerous times over our 21-year history, there's a few interesting things about inflation. First of all, you know, economists still debate what causes inflation exactly and what to do about it.

Starting point is 01:16:40 So it's pretty interesting. And what is the big driver of inflation also tells you what asset classes might do better versus not. So it's kind of tough. You can look back into the 70s where you really had this cost push inflation. A lot of it was driven by the oil crisis and you know, you had these high labor costs. You know, you had a lot of labor unions in the 70s that, you know, a much higher percentage of workers were in labor unions. So it was really hard when there was, you know, low economic growth or declining profitability. You couldn't really cut wages and things. So that was like one situation. And we've had different situations that have been more driven by monetary policy. So, you know,

Starting point is 01:17:16 the Fed being too loose for too long. And then you have you have times like we have now that are probably a combination of a bunch of different things is partly driven by monetary policy, but definitely fiscal spending and the rescue that was done out of COVID, but then combined with all these supply chain issues. And in each era, you can't just say this is the investment asset that's going to work. And you look at tips, Treasury, Inflation, Protected Securities. And those haven't done well over this inflationary time period because this inflation adjustment has been overwhelmed by the rise of interest rates and there wasn't a buffer. So it's tough to say exactly what you should be in as an inflation hedge. I'll tell you, during all these time periods, if you look long term,

Starting point is 01:17:55 the best performer relative to inflation has just been equities. So whether public equities are private equities, so we've pretty much have stuck to our original asset allocations with clients. We know that there are time periods that's not going to look as good and others that it's going to look better. I'll tell you, like, for the history of our firm, we've had an allocation to non-U.S. stocks. And, you know, that was great in the aughts. But since the financial crisis until 22 and so far this year, it's been a huge drag while clients going, oh, my gosh, like, you know, will the pain never end? And we're like, you know, let's continue to rebalance and buy more international stocks and it'll cycle back. And that's really how we view, you know, these asset allocations.

Starting point is 01:18:37 And, you know, for instance, if we had a client that's 60, 40, we would say the best, the best investment behavior you can have is not outguess it and to continue to rebalance back to 6040. Yeah, it's been, you know, it was 22 was brutal for a bond investor, but, you know, bonds are looking more attractive now. You know, they're going to look, you know, better and worse over time. So we're really about behavior. You know, what's, you know, what gives you the best behavior? And we find for investors, it's having more of a static asset allocation and trying not to out guess. And we've done a lot of paying attention to what other firms do in terms of their tactical allocations and they're right sometimes, but they're wrong a lot. And, you know, a lot of times

Starting point is 01:19:16 they don't work out. And I think an issue is investors feel like they should be doing something when most of the time, the better thing to do is not to do anything. So, you know, I think, you know, people worried about inflation and interest rates and the allocation of their portfolio are better just to back up and think more in like 20 and 40 and 50 year timeframes. And just realize, you know, an important mental model is you're not going to, you're going to be wrong as much or more than you're going to be right, probably. And again, not have overconfidence and realize that there's all these other people that are in the market. And the price of everything is established by buyers and sellers. And, you know, people tend to think, oh, well, I know more than

Starting point is 01:19:55 these other people do. You know, when I'm selling a stock, woohoo, and look at those dumb buyers or, or, you know, vice versa. And to have a little bit more humility and say, there's all these other people, all these other firms, and realize that they have a reason for what they're doing. And that's part of the thing that's setting, it's setting the path of interest rates and it's setting what's happening in the stock market and realizing that maybe, you know, you don't know more than they do. And maybe even if you did, would that really help you? So I think it's just a big healthy dose of humility. Well, John, thank you so much for coming on the show. This was absolutely wonderful. If the audience enjoyed this episode, I'd encourage you to go check out John's new book, The Uncertainty

Starting point is 01:20:36 Solution. John, before I let you go, how about you give the handoff to learn more about you and learn more about your book and whatever other resources you'd like to send them to? Yeah, so I have a website that is John M. Jennings.com, J-O-H-N-M-M-is-I-M-is-in-M-is-in-M-is-in-M-M-is-in-M-M-is-in-M-M-is-in-M-old. And on it has a little bit about my book, but importantly, in the menu, there's a tab that says IFOD, which stands for interesting fact of the day, and that is my blog, that about twice a week, I write on things that have usually nothing to do with investing. They're just things that people, you know, might find interesting. So it's very, very wide-ranging.

Starting point is 01:21:15 Some of my most popular ones have been, what happens to a bullet shot straight up in the air? Why do females generally have neither handwriting than males? Why do competitors often put stores close to each other? Like, why do you see a CVS and Walgreens on the same block or a lows in a home Depot, you know, why does that happen? So yeah, it's just, you know, various interesting things like that. Would, you know, love always to have more subscribers to my blog. Awesome. Well, thanks again, John. Really appreciate it. Yeah. Thanks, Clay. Enjoyed it. Thank you for listening to TIP.

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We Study Billionaires - The Investor’s Podcast Network - TIP554: Mental Models for Successful Investing w/ John Jennings

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