Clay Finck (02:57):

For example, if a financial advisor told someone in their 20s that they should be invested in a diversified 60/40 stock bond portfolio, they may just say, “Okay, that’s what I’ll do because it’s likely that others in the same position as me probably follow the advisor’s recommendation.” When in reality, it might actually be wiser for this person to be a hundred percent invested in stocks because of the long time horizon they have ahead of them and their ability to take on a bit more risk. During these mini episodes, I’ve talked a lot about how most people should have the majority of their money in index fund. For someone that is younger or a millennial, this might be difficult for someone to do.

Clay Finck (03:40):

There are many people on Twitter talking about individual stocks and trading in and out of things such as cryptocurrencies and individual stocks, or many of our friends might be doing that. So, for you to have most of your money in index funds might be your way of straying away from the crowd as a lot of people in that environment just don’t take that approach because it might seem boring or it might seem uninteresting even though it’s likely that even with all this trading in and out of individual stocks and crypto, they’ll likely underperform a simple S&P 500 or a simple investment approach.

Clay Finck (04:14):

The next bias that Scott covers in his book is the disposition effect. The disposition effect is the tendency to defer regret by holding on to losers and to avoid being greedy by selling our winners. Even worse, it would be to sell your winners to allocate to your losers and you eventually end up with a portfolio full of bad companies. As Scott put it, “The most powerful element in investing is time, and you’re wasting it by sticking with an investment that isn’t working.” To keep yourself from falling prey to the disposition effect, Scott recommends sticking to index funds. As you won’t be allowed to mess around with your portfolio allocation within the funds, it does all the rebalancing for you automatically. To me, this is one of the most difficult biases to overcome.

Clay Finck (05:04):

On the one hand, I could see that a particular stock or asset class might seem to be overheated, so I could see the case to sell your winners to rebalance to some other positions. Additionally, the best performing investments tend to be the most volatile. So, I can see why selling when it is overheated and there’s a bit of irrational exuberance can help you sleep better at night because eventually, there will be a big drawdown, you just really don’t know when. On the other hand, if you’re holding a really good company that you really like, it’s oftentimes wise to hold on to it and just let it compound over time. Given this, I think the disposition effect is just one of the really difficult biases to overcome and just really grapple with in your investment approach.

Clay Finck (05:50):

The third investment bias I wanted to touch on during this episode was overconfidence. Overconfidence can lead us to making some really simplified and dangerous assumptions and investments. This is why bubbles occur. People see that a stock has doubled over the past, say three months. So, they think that that trend must continue and they think it’s very likely to continue, then they’re very confident in that assumption. Overconfidence can lead investors to taking on leverage and that’s almost never a good idea. It can lead us to not being as diversified as we might should be or it could lead us to having a high allocation to investments that are very risky. Many people oversimplify investing when in reality, the economy and the financial system are extremely complex. And it can be dangerous to assume that you need to over allocate towards one particular stock or asset class because you know so much more and understand the world better than anyone else when in reality, it’s probably not actually the case.

Clay Finck (06:53):

The fourth bias I wanted to cover is loss aversion. Loss aversion is the human tendency to dislike losses to a greater degree than we’d like gains. This bias also ties into the disposition effect which I mentioned earlier in that many people tend to hold on to their losers because you don’t really lose money until you actually sell your position. So, if you hold on to a losing company, you might still be hoping that eventually it will get back to where you bought it at. I think that loss aversion also keeps people from investing in the stock market overall. Even though you’re very likely to make money in stocks if you have a five to 10-year time horizon, many people look at what happened in 2000 or 2008 and think that they can’t afford to lose over 30% or 40% of their money in stocks. So, they end up holding something that is perceived as much safer such as bonds or cash, even though they could have made much more money just continually buying and holding stocks.

Clay Finck (07:52):

It’s important to remember that there will always be many days or even months when the stock market is down. But when you look at the data, the stock market is up 87% of the time when it’s held for a five-year period. The overall stock market’s up 94% of the time when held for a 10-year time period. As you extend your time horizon, you increase your chances of making money in stocks. Even when looking at just a one-year period, stocks increase 74% of the time. But when you zoom into a single day, stocks are only up 53% of the time. So, it’s essentially a coin flip or a total gamble when you’re just investing for one day. So, down days and down weeks are really to be expected and they’re really pretty common. And occasionally, losing money in the stock market is expected, losing in quotes as “You really don’t lose money until you sell.”

Clay Finck (08:47):

But when you hold stocks for a really long period of time, it’s likely you will end up making a good return on your investment and at least get your investment back. I think loss aversion also plays into stock market crashes as well. Take the COVID crash for example. On February 19th, 2020, the S&P 500 topped out at around $3,380. On March 23rd, 2020, the S&P 500 hit roughly $2,200. This is a 35% drop in just over one month. Think about what it would’ve been like to have say $500,000 in your retirement account and you log in on March 23rd and it’s down at $325,000. And on top of that, you have this new virus that we really don’t know anything about. People are starting to die from it, everyone’s getting sent home from work to work from home, schools are shutting down, we’re being told to stay in our house and not get together with others.

Clay Finck (09:49):

For someone that doesn’t know about a ton about investing, losing nearly $200,000 in a month really hurts. And in fact, it could hurt so bad that this person just wants the pain to stop and avoid any further pain from occurring. They might actually sell their positions because COVID is going to potentially just totally wreck our economy. This is what happened to some investors because they got too emotional in their decision making and failed to see the big picture and extend their time horizons to save five or 10 plus years. The last bias I wanted to touch on during this episode is anchoring. Anchoring is this idea that the price of a stock or an asset influences your judgment on what you believe in the asset is worth.

Clay Finck (10:35):

Say you are house shopping and you come across a house you’re interested in that has a listing price of $300,000. In order to feel like you got a good deal, you might want to offer 270,000, which is a 10% discount off the asking price. If you do end up paying 270,000, you may feel like you got a great deal. I mean, it was 10% below the asking price, right? But what if a similar house across the street sold for 200,000 the month prior? Well, even though you paid less than the asking price, you may end up paying well above what the house is actually worth. This is why your realtor might run comps and look at similar sales in the past few months to determine what the home is actually worth and not just consider the asking price and anchor on that price.

Clay Finck (11:23):

I think so many investors fall into this trap of anchoring. They might buy Tesla’s stock at say $1,000 per share. And if it drops to $600, they’ll tell themselves, “Oh, the stock was just trading for a thousand. It’s likely that it’ll get back to that point in the future,” when really, many stocks that pull back substantially may never recover. The market does not know and the market does not care what price you paid for the company. And I’m not saying that Tesla’s never going to go back to $1,000 per share, I’m just using it as an example as many of these high growth companies are down 70%, 80%, 90% and many of them may never get back to the high prices they were at just one or two years ago.

Clay Finck (12:08):

This reminds me of Warren Buffet and his big emphasis on calculating the intrinsic value of a stock. When Buffet researches a company, he really doesn’t pay much attention to what the stock is trading for in terms of its price. He’ll read the financial reports and come up with a conservative estimate of what he thinks the company is worth and then he might check the stock price to see if it’s trading at a price well under what he thinks it’s worth. Here’s a quote I pulled from Scott Nations related to anchoring. “The tool for overcoming anchoring is to forget your purchase price. And remember that every stock is worth only what the market says it is in that moment. What you paid six months ago or two years ago is irrelevant other than for tax purposes.”

Clay Finck (12:55):

“Then ask yourself what you think the stock will be in the future based on a timeframe that makes sense for you and why you think it will be there. It’s impossible to know, but if you have a solid, fundamental response about other investors overreacting and selling the stock down because of a disappointing earnings report, then hang on. If your answer has to do with where the stock has been, you’re not thinking productively.” I didn’t cover all the biases that Scott Nations did in his book, but these were the most important five that I found and many of them are interrelated in some way.

Clay Finck (13:31):

All right. That’s all I had for today’s episode. Be sure to check out Scott’s book, The Anxious Investor if you’re interested in looking back at history and applying the lessons he lays out in his book on the behavioral side of investing. Also, be sure to check out my episode with Scott that’s coming out this Thursday. You can click Subscribe on your podcast feed so you can get automatically notified when that episode gets released on Thursday. I will link the book in the show notes for those who are interested as well. If you guys have any questions related to anything I discussed during this episode, feel free to reach out to me. My email is clay@theinvestorspodcast.com and on Twitter, my username is @Clay_Finck. That’s C-L-A-Y underscore F-I-N-C-K. Thanks for tuning in. We’ll see you again next time.

Outro (14:20):

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