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Behavioral Investing Theory
229 Plays2 years ago
Certainly, with all the fancy computers and smart math folks in the world, there has to be a magic formula out there that balances risk and returns and gets the best investment returns out there for everyone, right? Even if there was such a thing (and we'll discuss modern portfolio theory out of the gate), there is a common variable that makes makes the math inadequate: You.
Yes, humans are an unpredictable bucket of erratic of behavior who can spoil even the most prudent and successful investing theory. That's why it's important to factor in human behavior when making with, sticking to, and bailing from investment decisions. This week we'll talk about the behavioral investor theory and the things humans are prone to that can poison their own well, including having a confirmation bias, holding on to losers too long, taking on excessive risk due to overconfidence, and many more.
To learn more about our philosophy, check out uncommonwealth.com, listen to the back episodes of this podcast, or shoot us an email at podcast@uncommonwealth.com.
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Transcript
Introduction to Uncommon Wealth Podcast
00:00:00
Speaker
Everyone dreams of living an uncommon life and the best asset you have to achieve your dreams is you. Welcome to the Uncommon Wealth Podcast. We're going to introduce you to people who are living uncommonly. We're also going to give you some tools and strategies for building wealth and for pursuing an uncommon path that is uniquely right for you.
Value of Time and Financial Alignment
00:00:26
Speaker
Hello and welcome everybody to another episode of the uncommon wealth podcast where I'm your host Philip Ramsey and I am Aaron Grammer. Thank you for tuning in. Thank you for taking your precious time, your most valuable resource time to listen to our podcast. Thank you.
00:00:41
Speaker
We are advisors for those who don't know that actually like what we do and we like our clients and we think that you are your best asset. And so we want to help you align your money in order to get yourself passionate about what you do every day. Sounds great, but how do you do
Unique Money Management Philosophy
00:00:57
Speaker
it? We have a unique process and other episodes before this probably talks about that unique process, but today,
00:01:04
Speaker
we wanted to talk about managing money, which is a pretty big deal for advisors, right? And it's taken, I've been in this industry almost 11 and a half years. Uh, it's taken this long to formulate what my philosophy is on the managing money side of things. Uh, and in fact, in on the show, we have had money managers,
00:01:27
Speaker
come on and we've interviewed them. Um, I think Howard capital is one of those, I think we even had Clark capital at one point. Money managers are people that, uh, have developed a company. They feel like they have a philosophy that's powerful, valuable for clients and they'll manage money.
Understanding Financial Fees
00:01:43
Speaker
Well, in the past we have at uncommon wealth bought into this, Hey, money managers can manage money probably better than we can. Um, and we've done that. Well,
00:01:53
Speaker
If you do use money managers, a lot of times you have to think that they don't do that for free. Yeah, they don't. They charge a fee, and then we charge a fee, and then a lot of times we put your money in someplace called a platform, and the platform has fees, and then the investment managers will then invest your money, which also has fees. So there's four fees right there that are just exposed.
00:02:20
Speaker
the platform fee, there's the investment fee, which anytime you put money in the market, I shouldn't say anytime. Most of the time there's going to be fees in that. So that's pretty minimal. Then you have money managers. Then you have the platform fee. I can't remember all of it, but there's the four. And then you have us, the advisors. So maybe I duplicated one of those, but then you have the advisors. And so what we're trying to do is you got to control what you can control and what we can control is fees and our philosophy.
Creating Cost-Effective Portfolios
00:02:50
Speaker
And so moving forward, we are under the impression that we can put together a portfolio and make it cheaper for our investors. And we can put together some kind of an investment strategy that one is matched the risk and the fees are way lower than they ever have been.
00:03:09
Speaker
Uh, I, I like that sound of that. So, uh, we're going to today talk about kind of what we've fallen on and as an investment strategy moving forward and kind of how we got to this point and all that stuff. Where do you want to go from there? Aaron, I've set us up, buddy. Yeah. Well, I, I think it is like, just to recap real quick on all that to shorten it up for listeners.
00:03:31
Speaker
is really what we're trying to do is make sure less mouths are getting fed before our clients get fed. Hands in the cookie jar. Yeah, it's like get out of the cookie jar. The client's cookie jar. And fees are real. They're a drag. If you start looking at things all over the long term, it's real.
00:03:50
Speaker
and we gotta make sure if we are getting paid to do this that we are actually doing what we're doing and we're worth the fee that we're adding on it. That's valid. So let's start to, when we start doing research on this, really, there's two factors here. One, history.
00:04:08
Speaker
that history of the philosophy, I guess you'd call it, the theory. And then also it was big for Aaron and I both to have a mentor in this. We talk about this a lot. We say the cheat code of life is mentorship. And so we wanted that, but we also wanted a history that we could go back and back test it and just see what happens. Now, here's what I will say about this.
00:04:32
Speaker
we can't manage people's money the way that they might invest themselves in that. If they want to do specific individual stocks, they want to do all this stuff. Now we can do that, but we have to do that for a higher net worth individual. Yeah. Cause what we can do is we can't, if someone comes to us and I want 20% of my portfolio to be in Tesla, we can't do that legally. Like we just, that's not in your best interest to do that. And cause mathematically it's shown that we can't do that. So we won't.
00:05:01
Speaker
Yeah, so that's something that I just wanted to be upfront and honest with. Now again, for a high net worth individuals, a lot more opens up for us. But for our average person, this is kind of what we're talking about, is how do we manage money? What's our philosophy?
Modern Portfolio Theory Basics
00:05:19
Speaker
And it all boiled down to us was modern portfolio theory.
00:05:23
Speaker
The old MPT, the Modern Portfolio Theory. And so I just pulled this from a definition on the internet, but this is what it says. I'll read through it and then we'll talk through it. So Modern Portfolio Theory is a financial framework that was developed by Harry Markowitz in the 1950s. It is a mathematical approach to a portfolio construction that emphasizes the importance of diversification and risk management.
00:05:53
Speaker
There we are. All right, the theory suggests that investors can maximize return while minimizing risk, all by constructing a portfolio of assets that are not perfectly correlated. By combining assets that have different levels of risk and return, investors can reduce the overall risk of their portfolio without sacrificing potential returns. NPT, or Modern Portfolio Theory, also introduces the concept of the efficient frontier.
00:06:22
Speaker
which is a set of optimal portfolios that offer the highest expected return for the given levels of risk. The efficient frontier helps investors to identify the portfolio that best meets their needs, tolerance, and investment goals. The efficient frontier.
00:06:46
Speaker
Modern portfolio theory has a significant impact on the field of finance and has been, has become a widely accepted approach to portfolio management. So that's where we started. That's a little mouthful there. Especially for Philip to read it. Let's be honest. I'm not that reader. Let's be honest. But, uh, the efficient frontier and modern portfolio theory is kind of what Aaron and I started landing the plane on. Hey, how do we construct the appropriate portfolio for clients?
00:07:12
Speaker
in order for them to succeed in the market as inefficient or the fees as low as we possibly can. This is what we landed on. Here's another thing that we've adopted into our practice. I was just gonna get into this. I love modern portfolio theory, and we like math. We're financial advisors. We're geeks. Yeah, but the one thing I think me and Philip both really enjoy a bit more than math is the psychology of people. You know, because we love people.
00:07:42
Speaker
Right and the modern portfolio theory does have one big like Hole in it. Oh, yeah, it does and we're gonna talk about that Yeah, that's what we're gonna get into this other but I was first gonna say our process is before we manage anybody's money We like people to do a investor profile. What kind of investor profile?
00:08:03
Speaker
a psychological, like what is the portfolio risk that we should put to? And we like to try to take the emotion out of it. Hey, here's a third party, we already pay for it. Take this investor profile and it comes out with your risk tolerance.
00:08:21
Speaker
So it's a very non-biased approach. It's not Aaron and I like, eh, you're young, you should have this risk tolerance. It's not that. But I ask you good questions towards money, not towards just in life, because your risk tolerance can be totally different towards something else. Yeah, right, right. So we do have all of our clients that, I shouldn't say all, but as many as we can, we like to at least have them do this investor profile that gives us a risk tolerance. And then as we were doing research in this modern portfolio theory, what did we find?
00:08:50
Speaker
So modern portfolio theory states that, because it's mathematics, we love mathematics, and if you, you know, and I think that's like 85% of our portfolio is modern portfolio theory.
00:09:03
Speaker
It states that everything will work out the way you need to work out as long as humans act rational. Yes. I don't know for our listeners, but I don't, I think we can all look around and say, I'm not rational a hundred percent of the time you get emotional and you can't be rational. So, um, that's where modern portfolio theory and the, the mathematics of it breaks down in our, in our thought. Yes.
00:09:27
Speaker
And so we started like, okay, well, what happens when modern portfolio theory and people start acting irrationally? What happens?
Behavioral Investor Theory Introduction
00:09:35
Speaker
Yeah. So, so we get into the behavioral investment theory. Yes. So that's the end of like back up a little bit. This is the fun part. How me and Phillip were like, Oh man, we want to manage these portfolios for people, but like, how do we find a veteran that can do this and mentor us? Yeah.
00:09:49
Speaker
Well, that's the fun part. We found one. Yeah, we sure do. I bought him a book. I was like, hey, everything you're describing, because we felt like we were good. I was like, I think it's this. Will you read this book? I took it to his office because we were doing a little lesson.
00:10:02
Speaker
He's like, Aaron, I've already read that. And you're right. I was like, sweet. It's so good. And so the book that you bought and you've read is called Behavioral Investor. And so I feel like our new philosophy is almost like Behavioral Investor Theory, which is based a lot on modern portfolio theory. A lot of it, most of it is.
00:10:23
Speaker
Yeah, so this book, here's the top 10 things that are important in that book. Do you think that's a good way to approach it? I think that's really super fair. All right, so behavioral bias can have a significant impact on investment decisions and is important to be aware of them. Yeah. So that's like the first and foremost, and that's kind of what you said, is like, hey, when people start acting irrational, what happens to modern portfolio theory? Because mathematics go out the window. Yeah, and we're talking about, I mean, when you were buying things,
00:10:53
Speaker
You're buying stock and something. And if everyone goes and buys and then pulls out, it affects your return. You better believe that. Yeah. Because someone might get scared. Oh, man. And the whipsaw event of that deal is real. Yeah. OK. So that's just, I think, the key basis is behavioral bias can have significant impact on investment decisions. Yep. And then the next one is overconfidence can lead to excessive risk taking and poor investment decisions. Yeah. It's a big one.
00:11:23
Speaker
So let's talk about that. I think this is important and why we have introduced this, uh, investor profile for our clients, because for about eight years, I felt like the market was just going to gangbusters. Yeah. And everyone was like high risk, high risk. I love this, these returns.
00:11:42
Speaker
Yes. Until they started going down. Yeah. Then their risk tolerance changed quite fast. Right. And we talked about the sufficient frontier, but basically it's saying that people's risk should be commensurate with what kind of loss they're willing to take. The way that I kind of communicate this is like, what kind of roller coaster do you want your money to be on?
00:12:02
Speaker
Some people can take the dips and valleys, some people can't. And so what we've done to introduce and kind of, I don't know, mitigate the right word, but it's just, here's an investor profile, takes the emotion out of it. I don't care what the market's doing, it's gonna give us a good understanding of what your risk tolerance should be in a portfolio. And our hope is that if we get you in the right portfolio,
00:12:25
Speaker
You won't yank it and be irrational when the market goes down. Yeah, because you're ready for it. And then you can get conditioned, and your risk profile can change over time. 100% accurate. Yeah. So that's kind of number two. Yeah, number two. But then for us, though, too, as managers of portfolios, as long as we're building it, these are the same things we have to worry about as we're doing it, right? Yeah. So how do we combat that on our overcomes? Like, we and Mr. Know-It-All? No. Right.
00:12:51
Speaker
It's surrounding ourselves one with a good, you know, mentor, but I mean, I, we're both doing this, but constantly learning, learning is the number one way to bring down your confidence. But, and I found it down or bring up, bring up your confidence. No, it's bring down. Oh, it's bring down to learn.
00:13:09
Speaker
Like when you learn, your confidence goes down. Oh, interesting. Because you realize how much you don't know. You realize how much you don't know. So you constantly keep learning. You're humble. Yeah, you're getting humble. And then for us, it's reading more and more books. And the biggest thing we have to do and that we do is talk to people that don't believe the same things we do to challenge us. But also read books that go against what we believe and with an open mind. So anyways.
00:13:36
Speaker
Uh, so we've talked about overconfidence, but also fear and anxiety can cause investors to sell investments at the wrong time, leading to losses. So those kind of go hand in hand, but basically they're articulating. The first one is like, Hey, honestly, behavioral biases can have a significant impact. Yeah. Cause if you're too scared, like you, I mean, we see that right now during times, like look at the pandemic is perfect example, you know? Oh yeah.
00:14:00
Speaker
I mean, we all got, we all bundled down as a society and then things changed, you know, but like with the stock market and everything, but like the people that stayed tight, ran the path, we're good.
00:14:11
Speaker
Uh, then greed, greed is also something that can really change this, can lead to, uh, chasing hot stocks or market trends, which can result into poor performance. Um, yeah. So I think something that I've really resonated with this is it sounds great to then jump out of the market and go a hundred percent cash, but you've got to be right twice.
00:14:33
Speaker
Yeah. The first time of when to get out and the second time, which I think is even harder is when to get back in. Yeah. And so the only way that I shouldn't say the only way that was probably compliance snafu shouldn't say that a good way to not make money is to try to time the market.
00:14:49
Speaker
in and out, in and out, in and out. Cause you just don't know what's going to happen. And you always have this like buyers and more. So I should have done this if it's not the perfect bottom or if it's not the, Oh, I should have got in yesterday cause it's up 3% or whatever. Like it's constantly changing. So I'm saying putting it into a portfolio that your risk tolerance is commiserate with. And then we're going to try to figure out how to ride this storm, even when the market's not going according to plan. Yeah. So,
00:15:16
Speaker
All right, where are we at? Loss aversion. Oh, baby, which is totally a real thing. So talk to me about it. So loss aversion can cause investors to hold on to losing investments for too long, leading to further losses. So basically you think.
00:15:31
Speaker
that it's gonna come back, it's gonna come back, it's gonna come back. Like I know the stock's gonna come back, it's like where it should just be, you know, we gotta cut our ties. Yeah, right. Yeah, and I think this is where I hate that saying, set it and forget it. Have you ever heard advisors, hey, give me your money, set it and forget it. Like that couldn't be a worst.
00:15:49
Speaker
like philosophy. So don't, please don't set your money anywhere and forget it. Yeah. That's not the play. But what I think they mean is like, Hey, how do we take the emotion out of it? Yep. That is, that is actually pretty sound advice. Yeah. Cause there is times in the market and our economy when some portions of the stock market is more negative coefficient than other times. Yeah, for sure. It's something that, uh,
00:16:14
Speaker
our mentor said that was like really, it hit home for me. He's like, Hey, when you're ready, and he was like pretending he was talking to a client, when you're ready to throw a brick through my window, could you attach a check to it? Because we're going to put it in the market. And that's usually the time of like, buy more. The market's a really good value to buy into. And I was like, that's really interesting. Cause I think that's kind of going to this loss of version, you know? Yeah. Okay, go ahead.
00:16:42
Speaker
Confirmation bias can lead the investors to seek out information that confirms their existing beliefs rather than considering all available information. So kind of touched on this over confidence. I think you're right. So that's good. This is the biggest one I know our our mentor says he tackles the clients. So is
00:17:07
Speaker
confirmation bias. People want to know, think they're right. Yeah. And this is, this is really like not only just, you can pretty much apply a lot of these to many areas of your life, but like you can always surround yourself with crazy.
00:17:22
Speaker
And like, but is that crazy? Great. Like, you know, like, Oh, I feel like underwater basket weaving is the new like sport that everybody should do because all you're looking at is underwater basket weaving stuff. Yeah. What a dumb example, but you get it.
00:17:37
Speaker
And so everything you do, you surround yourself with underwater basket
Cognitive Biases in Investing
00:17:41
Speaker
weavers. That is the best underwater basket weavers you've ever seen in your life. And then not only that, but now AI is starting to show and show you stuff on your phone that you're constantly seeking out of like how underwater basket weaving is the new sport and blah, blah, blah. How do you pull yourself out of it and like not have this confirmation bias? It's hard.
00:18:02
Speaker
I don't know how you do it. And I'm not saying I have a solution, but I think it's one just to recognize it. And I think, and how you pull yourself out is keeping an open mind, but also putting like math to paper, you know, and seeking out people to challenge your way of thinking, but not to argue with them and just show that you're right. It's a more like, show me how I'm wrong. Yeah, right.
00:18:24
Speaker
The anchoring bias can cause investors to rely too heavy on a single piece of information, such as a purchase price of a stock or one specific piece of information. And then they do their whole investment philosophy around that. Yeah. A big one on this where you see people do is that they have stock in the company that they work at.
00:18:45
Speaker
Oh, that's good. They love the company they work at. They're in there. They know it. They're operating there. And there's so many stories about people having the majority of their 401k and the stock of their company. And is it Enron? Enron. Enron. Yeah. So many people there were like, I know it. This is a great company. And they were interviewing people. I loved it. I thought that everything was going great. Week later, went under. Yeah.
00:19:16
Speaker
Okay, so the herd mentality, so basically causing investors to follow the crowd, even when it's not their best interest, it's interesting. I've always wanted to be the person that didn't do that, but I know how easy it is to be like, well, everybody else is doing it, we gotta do this. Yeah, everyone's getting out. Real talk. Yeah. I did this one time with cryptocurrency.
00:19:34
Speaker
zero. It is zero now. And I'm not saying that that, but that was something that everyone's doing. And I was like, I have no idea about this. I went against all of my philosophy in my life. Yeah. Uh, zero Aaron zero. That's what that is now. Um, and I was just kicking myself because like, well, one, it's a great lesson, right? Follow the lessons, follow the stuff and like follow the advice that you actually give people fill up.
00:19:57
Speaker
Yeah, and if you don't know anything about the investment might not be the best thing like this could be a herd mentality Totally was and so good lesson to learn. Yeah, cuz I mean everybody I think the word this really happens is when you look at back things like, you know Apple
00:20:12
Speaker
everything like this, and you're like, oh my gosh, if I just would have bought Apple. Like everybody else. That's $6. Yeah. So then you get so scared because you want to do those things, you want to take those opportunities, or you want to lose those losses. But the thing is, is you can't. No, you can't. We haven't been able to. And I think it's unrealistic. And so this next point is like, how do you
00:20:34
Speaker
How do you try to minimize some of those risks? And it's just a discipline and systematic approach to investing can help overcome behavioral biases, which we've talked about a lot of them. And then developing a long-term investment plan and sticking to it can help avoid making impulse decisions based on emotions. So that's kind of the book that, you know, you've read and then our mentor has read, I've scammed for the record, Gleanell Phillip.
00:20:58
Speaker
And so, uh, but it's really good stuff and it's really helpful to know and have our listeners and our clients know how we like to manage money moving forward. And so let's, let's keep fees low. Let's really try to do a good job, uh, developing a discipline and systematic approach, which we feel like modern portfolio theory is a great tool. And it's behavioral theory is also amazing. That little gap that it has.
00:21:23
Speaker
Right. And, and then, um, you know, like for a higher net worth client, they have the ability to handle a couple of different things that maybe we can have more strategic and intentional strategies for them. Um, and obviously like those take a little bit more, um, time and expertise. And so because of the bigger amounts, we get paid differently as well, or I shouldn't say pay differently. We get paid more. And so we just want to provide as much value. It's also like the bigger count. There's that plus the fact that like when you take someone's,
00:21:53
Speaker
you take a different strategy within a portfolio, a 3% of their portfolio, on a bigger account that's much more money to leverage those strategies, whereas these smaller accounts, 3% doesn't really get you too much to leverage those things. That's a good point. So we do, and full disclosure, we can do options for people. We can do a lot of different quirky things, but we just have to make sure that, one, the risk tolerance can handle it. Yep.
00:22:17
Speaker
And then two, that they have the understanding of what we're doing. So they're not like, I have no idea to fill up like it's gone. Like you always want to know something about what's going on. You might not have to be the expert of it, but you have to have at least a good understanding of what's happening. So we want to make sure all of our clients are informed with that stuff. But, uh,
00:22:35
Speaker
Man,
Insights on Behavioral Investment
00:22:36
Speaker
that's it. Yeah, but we gotta touch on my favorite part of this book, though. Oh, let's go, Aaron. All right, so real quick, this is one of the super powerful, and around this time I was reading this book, this is where I realized I'm not managing my own money. Ah, okay. Because it's me, meaning it's my money. It gets really emotional, right? My modern portfolio theory is great until emotions kick in. Yeah.
00:23:01
Speaker
So it takes a lot of brain power to like manage your emotions. Like it takes a lot of energy. So when those decisions come into play, you have to be able to think through it and all those 10 things that we just listed off, you have to combat all those.
00:23:19
Speaker
Yes, and I don't know if you're if you're anything like me and Philip I'm sure everybody listening has had a day when you come home from work, and you're just like whoo That was a day, and you're exhausted you can't even make a decision like you start stuttering over words right now Philip
00:23:34
Speaker
I got this fun question I gotta ask. All right, do you have some first? No, I think that's good. All right, that's good. So in this book it talked about, and it told a statistic of how many decisions an average person makes a day. I want you to try to answer how many. And so full disclosure, Aaron asked me this before the podcast, and I said 3,000.
00:23:53
Speaker
And I was like trying to go high. Yeah. 36,000 was what you told me. 35 or 35,000 decisions that the average person makes in a day. Yeah. Which is mind boggling. So mind boggling. Like how many, that has so many decisions. Cause you think it, you start breaking it down. What pair of socks are you going to wear? Like what shirt you're going to put on? How are you going to do your hair today? Like all these things, but it all takes energy to make these decisions.
00:24:19
Speaker
Oh yeah. Are you going to turn left? You can turn right. Some take more energy than others. Yes. Right? Like, especially like when you're talking to somebody specifically about maybe a pretty sensitive topic. Yeah. Like that takes some negotiating. Yep. And you're making decisions like, how am I going to ask this question? How am I going to work this question in? It's good. All these things. So with that said though, that's where I came to my conclusion. And
00:24:41
Speaker
is when I'm managing, granted like my money is in the same portfolio as our clients. Yeah, that helps. But mine comes to the point where like, am I gonna pull out like for this thing or am I gonna put more money in for these goals? You know, so I, you know, like I've always shared like,
00:24:58
Speaker
Philip is the one that can push that button, I can't on my account. So anyways, for everybody out there, I think people can manage their own assets if they have the capacity to do this. And the desire to want to learn more. We really do feel like that. That's something kind of uncommon about on commonwealth. It's like, hey, you can do this yourself if you have bandwidth and you get excited about it.
00:25:25
Speaker
But I know we've kind of made in that realm of business owners and stuff. And they're making big decisions throughout the day. And they're doing a lot. And they're seeking a dream. They're not chasing things. And so they're seeking their passion. And so at the end of the day, this is one last thing they want to worry about. But for everybody else though,
00:25:43
Speaker
That's something to think about. After your end of the day, and let's just say you're the average person, you've made 35,000 choices, decisions. Do you have the bandwidth to make a few more on a super emotional topic, which is your money? That's a good point.
00:26:00
Speaker
So it's a good point.
Final Thoughts and Invitation for Feedback
00:26:02
Speaker
Okay. Well, that's just a little bit of behind the curtains of how we look at, uh, managing portfolios and the process in of that. And so if this is appealing to you, if you have any questions or you guys think we're crazy, which I'd love to hear that, uh, anything podcast at uncommonwealth.com. We'd love to hear from you. Uh, thank you for listening. Thank you, Aaron, for all the research you've done.
00:26:24
Speaker
Oh, thank you to our mentor. Man, we've got a lot of things to thank you. And then I think too, just like staying humble in all this, like we don't have all the answers, but we try to take the emotion out of some of the things and have a systematic approach about how we manage your money. Yeah. So you've been listening to the Uncommon Wealth Podcast. I've been your host, Phillip Ramsey. And I'm Aaron Kramer. Until next time, go be in common. Thanks for listening.
00:26:47
Speaker
That's all for this episode, brought to you by Uncommon Wealth Partners. Be sure to visit uncommonwealth.com to learn more about our services. Don't miss an episode as we introduce you to inspiring people who are actively pursuing an uncommon life.