Dr. Daniel Crosby Executive Director, The Center for Outcomes & Founder, Nocturne Capital
“Anyone taken as an individual is tolerably sensible and reasonable – as a member of a crowd, he at once becomes a blockhead.” – Friedrich Von Schiller
I travel roughly once a week to conferences where, in addition to eating overcooked chicken, I am typically asked to speak to financial advisors about the foundations of behavioral finance. As anyone who travels for business well knows, it can be tricky in a new city to try and determine where best to eat, sleep, or watch a show. And while many nice hotels provide a concierge to guide you, the concierge’s advice is ultimately limited by the fact that it is just one person’s opinion. Having been steered amiss more than once by a concierge with a palate less sophisticated than my own (for surely it could not have been MY taste that was in question), I quickly learned to harness the power of the crowdsourced review. Apps like Yelp, Urban Spoon, and Rotten Tomatoes provide aggregated reviews that guide diners and moviegoers to restaurants and films that have received consensus acclaim.
While I may not always agree with the taste of any individual concierge or my local newspaper’s movie reviewer, I have never been disappointed with a movie or dish that has received widespread approval. In things that matter most (i.e., food and movies), there is wisdom in the crowd.
But the power of crowd thinking is not limited to picking out a tasty schnitzel or deciding whether to watch Dude, Where’s My Car? (18% on Rotten Tomatoes) – it is the bedrock upon which the most successful political systems are built. Sir Winston Churchill famously opined that, “The best argument against democracy is a five-minute conversation with the average voter,” a sentiment heard in many forms at election time. So why then has democracy proven to be so successful (or at least not entirely unsuccessful) over long periods of time? Why is it, paraphrasing Churchill again, “the worst form of Government except all those other forms that have been tried from time to time”? The answer is once again in the tendency of the crowd to be more wise, ethical, tolerant, and gracious than the sum of its parts. The alternatives, political systems like oligarchy and monarchy, live and die with the strengths or weaknesses of the few, which is a much higher risk/reward proposition than democracy. The average voter may be unimpressive, but the average of the averages tends to be the best game in town.
If crowd wisdom can help us solve complex decisional problems and provides us with good-enough government, it seems intuitive that it has something to offer most investors, right? Wrong. Once again, the rules of Wall Street Bizarro World turn conventional logic on its head and require us to operate from a different set of assumptions.
Why is it then that a qualitative gap exists between investment and culinary decisions? Richard Thaler, behavioral economist par excellence, has identified four qualities that make appropriate decision-making difficult. They are:
- We see the benefits now but the costs later
- The decision is made infrequently
- The feedback is not immediate
- The language is not clear
Choosing a nice meal consists of clear language (“Our special tonight is deep-fried and smothered in cheese”), immediate feedback (“OMG! This is so good”), is made frequently (3 times daily, more if you’re like me), and has a mix of immediate and delayed costs (“That will be $27” or “I should have quit after three rolls”).
An investment decision, on the other hand, violates every single one of Thaler’s conditions. It consists of intentionally confusing language (What does “market neutral” even mean?), has a massively delayed feedback loop (decades if you’re smart), is made very infrequently (thanks for the inheritance, Aunt Mable), and has benefits that are delayed to the point that we can scarcely conceive of them (36-year-old me can scarcely conceive of the 80-year-old me that will spend this money). The crowd can provide us excellent advice on selecting a meal because it is a decision that is frequently made with results that are instantly known. Conversely, the wisdom or foolishness of a given investment decision may not be made manifest for years, meaning that the impatient crowd may have little wisdom to offer.
As we might expect from Professor Thaler’s research, the crowd gets it all wrong when deciding when to enter and exit the stock market. They enter at the time of immediate pleasure and long-term pain (bull markets) and leave at the time of immediate pain and long-term pleasure (bear markets). In A Wealth of Common Sense, Ben Carlson relates a study performed by the Federal Reserve that examined fund flows from 1984 to 2012. Unsurprisingly, “they found that most investors poured money into the markets after large gains and pulled money out after sustaining losses – a buy high, sell low debacle of a strategy.” Yet again we see that preferring the rules of every day to those of Wall Street Bizarro World means trading cheap emotional comfort for enduring poverty.
Jared Diamond’s book Collapse recounts the story of a people who tried to do what so many investors attempt in WSBW – inflexibly imposing their preferred way of life on an incompatible system. Diamond tells the story of the Norse, a once powerful group of people who left their homes in Norway and Iceland to settle in Greenland. The Vikings, who aren’t exactly known for their humility, doggedly pushed forward – razing forests, plowing land and building homes – activities that robbed cattle of grazable farmland and depleted the few extant natural resources. Worse still, the Norse ignored the wisdom of the indigenous Inuit people, scorning their ways as primitive compared to what they viewed as a more refined European approach to farming and construction. By ignoring the means by which the native people fed and clothed themselves, the Norse perished in a land of unrecognized plenty, victims of their own arrogance.
Like a Norseman in Greenland, you find yourself of necessity in a land with bizarre customs, some of which make little sense. This land is one in which less is more, the future is more predictable than the present and the wisdom of your peers must be roundly ignored. It is a lonely place that requires consistency, patience, and self-denial, none of which come easily to the human family. But it is a land you must tame if you are to live comfortably and compound your efforts. The laws of investing are few in number and easy enough to learn, but will initially feel uncomfortable in application. It won’t be easy but it is surely worth it – and it is all within your power.
The Center for Outcomes, powered by Brinker Capital, has prepared a system to help advisors employ the value of behavioral alpha across all aspects of their work – from business development to client service and retention. To learn more about The Center for Outcomes and Brinker Capital, call us at 800.333.4573.
The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Brinker Capital, Inc., a registered investment advisor.