Young Scrappy Money Podcast Ep. 034: How Our Brains Sabotage Our Investments With Behavioral Finance Expert Dr. Daniel Crosby

What do you get when you mix finance and psychology? A fascinating study on how our brains frequently lead us to some pretty irrational investment behaviors! In this episode, behavioral finance expert Dr. Daniel Crosby unpacks all the ways our brains can lead us to make irrational decisions with our money–as well as some neat tips to use those behavioral quirks to our advantage.

Resources from this episode: 

• Young & Scrappy, home to Michelle’s work as a financial advisor and financial coach.
• Nocturne Capital, home to Daniel’s work as an investment advisor behavioral finance expert. You can also find him on Twitter and LinkedIn.
• Daniel’s key books: The Behavioral Investor, Personal Benchmark, The Laws of Wealth. The Laws of Wealth is his newest, and comes highly recommended!
• A neat overview of Shlomo Benarzi and Richard Thaler’s Save More Tomorrow program.
• For the extra-nerdy among us. Seminal research papers by Meir Stadman (“Investor Overconfidence and Trading Volume”) and Terry Odean (“Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors”) on overtrading and overconfidence.
• The Behavior Gap by Carl Richards.
• Daniel’s Behavioral Finance Reading List for further nerdery. 
• Cartoon by Carl Richards, a summary of behavioral finance.
• Jesse G, my editor. If you ever need audio/video editing work, give him all your love and money.

Full transcript:

INTRO: [00:00:00] Hello. And welcome to the Young Scrappy Money podcast. I’m your host, Michelle Waymire. And each week, I’ll be bringing you tips and tricks to help you take control of your finances as well as interviews with people who made big financial changes in their own lives. So join us. And we’ll help you get your financial s**t together. 

MICHELLE: Hello, everybody. And welcome, welcome to another episode of the Young Scrappy Money podcast. Today, we are talking behaviors. As you know, when it comes to investing your money, managing your money, a lot of us have the very same hangups that apply to other behavior change activities.  

We don’t like to manage our money well. We don’t like to work out. We don’t like to make dietary changes. All of those behavior change activities can kind of be lumped together. And for most of us, they’re a little bit intimidating.  

So I think it makes sense to take a step back and think about behavior within the context of your money. Luckily for me, I have a guest expert who has come on to help. And since we both live in the wonderful city of Atlanta, Georgia, we’re actually recording this live in person, which is a bit of a rarity on this podcast. So I’m extra excited. 

With me today I have Dr. Daniel Crosby. He’s a behavioral finance expert, New York Times best-selling author, badass public speaker. And he’s the founder of Nocturne Capital. He was named one of InvestmentNews’s “40 Under 40” and a “financial blogger you should be reading” by AARP. Welcome, Daniel.

DANIEL: Thank you. Great to be here.  

MICHELLE: Um, so tell us a little bit more about your background before we get into the meat. How did you get into this type of work?  

DANIEL: Yeah. So I have a little bit of a strange background. I’m actually a clinical psychologist by education. My undergraduate degree is in psychology. And I loved it so much that, you know, three days after I got my bachelor’s, I started a PhD in clinical psychology with an eye to being a therapist.  

And so I found about three years into that program that I wanted to go a new direction. I was taking my clients’ problems home with me. It was just very heavy work for me. And I felt like I wanted to continue my study of behavior, wanted to continue to think deeply about why people made the decisions that they did, but didn’t wanna do that in a medical or clinical setting necessarily.  

So I began to explore other options. And my dad, who was a— was and is a financial advisor, said, hey, look, there’s a ton of psychology in what I do. And I wonder if there’s anything going on in that world. And it’s interesting. Because he’d never— you know, he would’ve never said the words behavioral finance.

But when I started to look into it, sure enough, there was a great deal of psychology to the stock market. And got a job straight out of college working for good ol’ SunTrust here doing pre-employment vetting of bankers. So I would give IQ tests and personality tests and things like that to bankers.  

And, you know, there my immersion in and love of all things mind and markets was born. And I kind of took it from there. So that’s sort of the quick story of how I came to be a behavioral finance guy from having started in the world of psychiatry basically.  

MICHELLE: That’s awesome. I actually feel like I almost discovered behavioral finance the other way around, where I decided that I was going to study business mostly because I thought I didn’t have anything else to do. I was like, I don’t— I wanna be able to get a job. And people in business can find jobs. And then I actually discovered that it was much more psychological than I had anticipated and stayed with it for the same reasons. It’s just so fascinating to learn about. 

DANIEL: Well, it’s interesting. Even if you look at all of the— you know, like the Nobel Prize-winning thinkers in behavioral finance, every one of them is sort of a mutt intellectually. Like they’re either a psychologist that learned the finance piece, or they’re an economist who learned the psychology piece. 

This is such a varied discipline. There’s no sort of straight shot to get here. So however you get here is the right way. 

MICHELLE: Yeah. So I think maybe to take a step back for some of our listeners who might not be as familiar with the field, talk a little bit more about the basics. So what is behavioral finance? And how does it differ from the more traditional financial study?  

DANIEL: Yeah. When you look at the traditional study of finance and economics, a lot of times it’s modeled on simplified assumptions about human beings that aren’t true in the real world. So we might assume for an econometric model that people always do the right thing, or that they always save what they ought to, or they always make rational tradeoffs with their money. And, you know, anyone who’s— anyone who’s ever been to Target or, you know, lived a day in their life can tell you that we don’t always act this way with our money.  

[00:05:05] So behavioral finance is simply a discipline that’s trying to re-inject the messiness of humankind into these models and to think about people when we’re thinking about money. And, you know, if you look at markets, people are the bottommost turtle. Like people are the subatomic particles that make up capital markets.  

How we think and how we act and how we feel, this is what drives the price and the worth of everything from, you know, the dollar in your pocket to the stocks in your 401(k). So people are really central to this whole equation. And we’re starting to learn that, that people in all of our quirky, irrational glory are a big part of this whole conversation.

MICHELLE: Yeah. I love that. Because I think you’re exactly right. The idea that the underlying theory is driven by perfectly rational humans who consider all of the pros and cons and then make the optimal decision every single time, I mean, that just doesn’t play out in real life. Humans are human.  

DANIEL: Yeah. I talked to a physicist today who was saying that they make similar assumptions in one of the measurements— I’m gonna mess it up here, but one of the measurements she was talking about— she had a PhD in physics. And she was saying, yeah, when you’re making this measurement, you just assume that everything in the world is shaped like a sphere. You know, everything in the world is not shaped like a sphere. 

And we did the same thing with our models of finance. We just assumed that every human acted the way they ought to. That’s certainly not the case.  

MICHELLE: Yeah, definitely. So I like the word irrational. Maybe walk us through some examples of common irrational investing behavior. What does this look like in practice?  

DANIEL: Yeah. So this is actually one of the hallmarks of my work. There are, I think at my last count, 177 documented types of bias and irrationality, cognitive missteps. There’s like 177 ways you can screw up your financial life.  

And so I looked at this list. And I was like, you know, this is unwieldy. This is crazy. No one can, you know, learn these 200 things and then scrupulously avoid them. And so I wanted to dig a little deeper on this.  

So in my last book, The Behavioral Investor, one of the things that I did is I looked at this universe of nearly 200 different types of misbehavior. And I looked at the psychological underpinnings of them. Like what are the core behaviors? What are the root behaviors that sit beneath these 200?  

And I entered this sort of intellectual exercise without any preconception about the number I would come out with. I assumed it would be smaller than 200. But, you know, I came out with four. And so there were four things that I think really affect how we think about money. 

So one of them is ego. Right? This is the propensity of us to be overconfident when making financial decisions. This is especially problematic in men are especially bad at this. And ego has a number of facets. But sort of overconfidence is the root there.  

One of them is emotion, which is this tendency for us to let our sort of heart lead our head when we’re making financial decisions and not the other way around. The third one is attention, which is our tendency to confuse things that are sensational with things that are probable. So, you know, you look at something like a market crash.  

Like we haven’t had a market crash in a decade, but we’ve hypothesized 400 different market crashes. Every time the market drops 1%, people freak out. Because it’s easy to imagine, and it’s scary. And it’s lurid. And it’s visceral. Right? So that’s attention. 

And then the last one is conservatism, which is this tendency for us to be sort of status quo prone, to be— to love what we know. And this leads people to make mistakes like underdiversifying. Whatever country you’re from, people tend to own way too much of the stock of that country and not be well-diversified into the rest of the world. But in general, we have this tendency to like things that we know or we’ve heard of. 

MICHELLE: Yeah. So just a reminder to all of the listeners, all of the resources that we mention in this podcast— books, blogs, you name it— all of that can be found on the show notes for this episode. If you go to youngandscrappy.com/blog, you can find a link to all of our episodes there along with all the resources that we mention. So we’ll make sure to link out to your book and anything else we talk about.  

So in terms of those like four big buckets of biases, we’ll call them for lack of a better word, um, I’m curious. When you were doing your research, was there any single one bias that you thought, boy, this is the really big one that people need to know about?  

[00:10:02] DANIEL: Yeah. I mean, overconfidence is sort of the gateway drug for all of the biases. Because, you know, overconfidence is the bias that begets all other biases. If you’re appropriately humble or circumspect about what you know and what you don’t know, then you’re OK, right? But if you’re overconfident, if you think you’re different, then all of these biases are magnified.  

So, you know, a common example, I had someone come up to me after giving a speech a while back. They had a large portfolio. Half of it was in a single stock. And, you know, half of it was well-diversified. Half of it was in a single holding.  

I basically said, you know, what are you doing? And he said, well, yeah, yeah, I know that you’re supposed to diversify. But I think I have like a good tip here. And they had, you know, a million dollars in one stock.  

And that’s— thats a primo example of overconfidence. Like, yeah, I know that these rules apply to the general public, like the person on the street. But I’m different. And that sort of “I’m different, I’m special, bad things don’t happen to me” mentality, uh, it emboldens all sorts of other bad decisions. 

MICHELLE: Yeah. That’s fascinating. I’ve— I’ve seen similar things play out with clients. Another big one in that area is people who work for a company that have some sort of stock employee plan.  

And they— they understand the company. And they love working there. And it’s a great place to work. And the product is fun. So naturally, you wanna buy as much stock as possible in this one company. And that’s dangerous. 

DANIEL: Well, it’s dangerous because it— it amplifies risk. You know, you think that the biggest financial asset you have at any given time is your job, right? So if you’re already employed at, you know, company ABC, and then you’re investing in there, and your economic fortunes are tied to them, you’re just stacking risks.  

And so, um, yeah, it— we tend to think that the things we know are safe. But oftentimes, they’re less safe because we’re so deeply embedded in it. We’re so entrenched in it. Um, so it’s a tricky conundrum for sure.  

MICHELLE: So all of these biases kind of put together influence our ability to make good investment decisions. What— how does that contribute to outcome? So like what are you seeing in terms of people who have more biases or a higher magnitude of bias? How is that impacting their investment results? 

DANIEL: Well, you take— um, you take one that’s sort of a stepchild of ego, right? And that would be action bias. It would be this tendency to overtrade or to do too much, which is very natural. 

Because many places in life, like if you want more of something, you do more. You know, you want bigger muscles, you go to the gym more. If you want to be smarter, you read more. And so people who are pursuing big things in the stock market will often trade more, keep a better eye on these things.  

Well, we find across 19 different countries we’ve looked at that the more you trade, the worse you do. That’s research by Meir Statman. Um, the more you trade, the worse you do in every single country that he looked at.  

And so that’s just one example of how this bias towards action or doing something versus doing nothing can lead you to really disastrous results. And they found that the delta between the best performing and the— or the least active and the most active, nearly 7%, which is effectively the entire return of the market in a given year. So not learning to manage these things can be very, very problematic and can lead to some massive, massive underperformance.  

MICHELLE: Yeah. I feel like I remember the catchy title of a paper, “Trading is Hazardous to Your Wealth.” 

DANIEL: Mm-hmm. 

MICHELLE: I love that catchphrase just because I think you’re exactly right. We— we wanna do more of the stuff that works. And sometimes that leads us to do more of the stuff that most certainly does not work. 

DANIEL: Yeah, absolutely.  

MICHELLE: So what tips do you have for people who want to recognize and address their irrational behavior? Like how can we use our emotions in our favor instead of against us?  

DANIEL: OK. So, um, you know, to— let me run with that second question. If we’re looking for ways to use our emotions in our favor, there actually are a couple of ways. And any time you can sort of roll with a bias versus trying to push back against it, that’s a win. And so I’ll give a couple of examples.  

You know, one of my favorite examples I wrote about in one of my books, and it had to do with people who were low-income savers having trouble putting aside money. Of course, they didn’t have much money. And, um, the researchers tried carrots and sticks, rewards and punishments. Nothing’s working.  

[00:15:00] And so finally they tried showing them a picture of their children. So they would, you know, show them a picture of their children for five seconds. And then they would make a financial decision with their bank account. And those who looked at a picture of their children for five seconds relative to a control group saved more than twice as much. 

And so that’s not rational. Right? Like that’s irrational. You should just save what you need to save. You should spend what you need to spend. It’s not rational in the strictest sense that looking at your kid should lead you to be, you know, a more aggressive saver.  

And yet we’ll take it, right? We’ll take that tendency, and we’ll run with it. So, you know, in viewing your financial planning and investing life with elements of what matters to you, naming those dollars, tying those dollars back to what’s important to you, can have an important impact on behavior. 

Likewise, socially responsible investing, investing in a way that’s consistent with your values, has been shown to improve behavior. So, you know, if you’re invested in— let’s say having women on boards is important to you. And there’s research that shows that having women on boards leads stocks— has historically led stocks to outperform those where there wasn’t equal female representation on boards.  

Let’s say you have an S&P 500 fund and a women’s leadership fund. When the market gets rocky, like which are you more likely to sell out of, this sort of impersonal fund or the one that’s consistent with your values? Both are examples of sort of pleasant irrationalities, if you will, that we can use to our advantage. Use those emotions to our advantage. Roll with that punch. And use it to make better decisions and stay the course.  

MICHELLE: So what I’m hearing is when you’re more emotionally connected to either the goal or to the actual investments that you are invested in, then that actually leads to better behavior over time. 

DANIEL: That’s right. 

MICHELLE: Cool. Are there any other examples you can point to of biases that might work in our favor?  

DANIEL: Yeah. There’s a— there’s a very profound one that saved American investors tens of billions of dollars. So this was a program that was developed by Professors Richard Thaler and Shlomo Benartzi. It was called Save More Tomorrow.  

So they were of course well-versed in this tendency of humankind to be sort of lazy and status quo prone. Like we make a decision, and we tend to stick with that decision. And so they said, you know, is there a way that we can use this and lock it in to our advantage?  

And sure enough, what they did was they pioneered a program whereby people would— you know, day one, you sign up at your new job. You automate the withdrawal of money every month. And you automate the escalation of that money over time. 

So let’s say, whatever, every year I get a 5% COLA raise. Well, I’m gonna up my contribution by 5% as well. Right? And let’s say 20 years from now, I make twice as much as I made today. We’re gonna automate the process of upping that saving over time. 

So it allows people to make a decision once to do the right thing and then to have that behavior, you know, trickle through the entire saving and investing experience. Now, um, you know, most people think, if we were rational, we would just make the right decision every time. Like, yep, every month we would redecide like, yeah, I’m gonna save this month. 

But we’re not like that. Right? We get lazy. We’re inconsistent. So if we lock in that laziness, and decide just once to set a positive status quo, and then stick with that status quo, it can lead to really powerful results. Um, Thaler won a Nobel Prize based in part on that program and has saved— you know, saved the American investor tens of billions of dollars by locking in laziness.

MICHELLE: I love that. Locking in laziness is extremely good. And, you know, even as somebody who is pretty financially literate, I am certainly a lazy human being. And so even people who know better, even people who have the means to save, there’s just a lot of external factors that sometimes get in the way of those goals. So I love that. I love that approach. That’s a neat program.  

DANIEL: Yeah, it is. 

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MICHELLE: I wanna talk about something that I am familiar with from your second book, Personal Benchmark, which is co-authored with Charles Widger of Brinker Capital. Um, how does that book redefine risk and irrationality to help people reach their goals?

[00:19:58] DANIEL: Yeah. So we talk a lot about in that book, you know, the true sources of risk. So if you look at the risk that most people are most worried about, it would be market risk. Right? You know, they’re worried about a market crash. And I think that so many of us are still scarred from the great financial crisis. Right? From the Great Recession and the accompanying crash that we saw there.  

Well, all of the research, though, suggests that this is not in fact the greatest source of risk— that, you know, keeping with our theme for the day, the greatest source of risk is you. Right? The greatest source of risk, but also the greatest source of potential benefit, is you and your own behavior. So there’s research by [INAUDIBLE] and a host of others that show that the average investor tends to underperform the S&P by about 2% to 4% per year.  

And if you compound that over a very, very long time— this is, again, due to fear, greed, timing the market, doing too much. Um, if you compound that over, you know, a 30- or 40-year investment timeline, you’re giving up about half of your return over that time. Um, over the last 35 years, we have had a market correction on average every single year. Every single year, the average drawdown in a given year has been 14% in any given year.  

The market crashes have always happened. I presume they always will happen. And that’s not the biggest determinant of whether or not you’ve made money. Because the markets finished up 27 of those 35 years and has compounded wealth dramatically over that time.  

So it’s really less about whether or not the market’s going to be volatile. Because it just will be. You should expect a 10%+ dip as regularly as your birthday. Right? Like it’ll happen every year.  

Um, but we— the best predictor of wealth and the best predictor of managing risk is just boring, unsexy decisions like we’ve talked about today— you know, maximizing your education and your job potential. Right? Like getting that number right. Saving, investing, automating the process of getting these things going over time, working with a professional to keep you out of your own way, these are much better predictors of whether or not you cross the finish line than, you know, your ability to time the next great crisis.  

MICHELLE: Yeah. That’s great. I love that you mention working with a professional— which, again, like as an advisor, I tell clients a lot, my job is not to make you have a sexy investment portfolio. My approach is very boring. Um, my job is to be the person you call when you’re panicking and to, like, talk about your feelings with you when the market goes sideways. Because— spoilers— it always will. 

DANIEL: Yeah. What’s— what’s wild to me is we know now. Like we in the industry know that this is the highest and best use of an advisor, of a professional. Natixis did a study a couple years ago that found that 83% of financial professionals say that the very biggest value they add for their clients is the very thing that you just talked about— handholding, coaching, keeping them away from a handful of really backbreaking financial decisions over a lifetime.  

And yet just 6% of clients listed that as the primary value-add of working with an advisor. So there’s this really big disconnect between what the research shows that advisors do well and how that’s perceived by the end client. The average client thinks that like, oh, you know, they’ve got me in hot stocks. Or like, they’ve got analysts working, and they’re gonna put me in the next big thing. That’s not, on average, what drives wealth creation. It’s just staying out of your own way.  

MICHELLE: Yeah. There’s a cartoon that I really enjoy by Carl Richards, which I’ll also link out to in the show notes. Because I realize describing a cartoon on a podcast is a little bit of a struggle.

DANIEL: Right. 

MICHELLE: Um, but the crux of it is basically you’ve got you on one side. And you’ve got something stupid on the other. And your advisor is this block in the middle to keep you from leaping over to the— to the stupid decision.  

So, um, I’ll try and put a visual aid in the show notes so that you guys get a sense of what that looks like. But that’s youngandscrappy.com/blog. Um, that’s your little teaser. Go check out the show notes and see this sweet cartoon.  

So you are— you are a scholar in this area. You do a ton of reading. Um, what other cool resources would you recommend for somebody who wants to learn more about investor psychology or behavioral finance?  

DANIEL: So this is the number one question I’m asked. And I’m asked it so much that I will plug my own reading list. If you just go google Nocturne Capital reading list, I have a whole list there of some of my favorite books in this space. There’s way too many to name. 

[00:24:55] Carl Richards, speaking of the person himself, Carl Richards’s book, The Behavior Gap, is quite good. It’s an introduction to this. My book,The Laws of Wealth, I would recommend as another high-quality introduction to some of these concepts. So I think those are two great places to start. But, you know, we can send you the list and link to it there as well. 

MICHELLE: Yeah. Make sure to check that out. Because if you think this stuff is fun, and you wanna nerd out on some behavioral finance, boy howdy, do we have the books for you. There are so many good ones out there. So we’ll be sure to link out to those. Um, this is neat stuff. 

DANIEL: Yeah.

MICHELLE: I’m here for it. Um, so I guess one other question, I wanna be respectful of your time. What key takeaways do you have for our listeners? What do you want folks listening to know about managing their money a little bit better?  

DANIEL: So this is a bit of a depressing takeaway. Apologies. So, um, one of the key things I found in my research is that education is a poor predictor of behavior. Right? I mean, as a person who educates and writes books and speaks on these things, it hurts me to say. 

But the fact is that just knowing the right thing to do and doing the right thing tend to be— tend to be very different things. You know, the example, sort of my go-to example, is the US started putting nutrition labels on food in 1993. And since that time, the average American has become twice as fat and three times as morbidly obese as a nation. So, you know, knowing what you should do is not a great predictor of what we actually do.  

So I think there’s three things that you need to make right decisions. The first is education. You know? So it’s reading books like mine, books like Carl’s, so you’re able to get the right education. And you know— you know the right questions to ask more than anything.  

The second thing you need is the right environment, which is the right portfolio. And an advisor can help you get that right portfolio that’s diversified between and across asset classes. But then the third thing you need is just-in-time encouragement. So you need that person that can, you know, stand in your way at the moment of fear and keep you from doing the wrong thing.  

You need the right education. You need the right environment. And you need the right encouragement or coaching. So until those things are in place, I think the average person has a very hard time making a go of it.  

Because candidly, everything you need to do to prepare for retirement is— runs contrary to what your mind wants you to do. Right? We are wired for immediacy. We’re wired for certainty. We’re wired for action. 

And being a successful investor requires taking risk, you know, taking on uncertainty, being inactive, being patient, uh, dealing with ambiguity. That’s nothing we do very well. And that’s where someone like an advisor can come in and hold your hand and help you make correct choices.  

MICHELLE: I love it. So where can folks find out more about your work and find you online? 

DANIEL: Yeah. So I’m very active on Twitter @danielcrosby. I’m on LinkedIn, Daniel Crosby, Ph.D. And I hope folks will go check out The Laws of Wealth. 

MICHELLE: Awesome. Thank you again so much for your time. And listeners, thank you for listening. It’s been a pleasure. Um, don’t forget please subscribe on whatever platform you get your podcasts. 

Leave us some love. Send us a comment. Rate us. And those are the things that allow me to keep interviewing rad people like Dr. Daniel Crosby. So thank you again. I appreciate you.  

DANIEL: Thank you.

END CREDITS: I hope you enjoyed this episode of the Young Scrappy Money podcast. If you want to read about my work as a financial advisor and financial coach, you can do so at www.youngandscrappy.com. That’s www.youngandscrappy.com. Thanks again for listening. 

Made with love by Jesse in Atlanta. [SMOOCHING SOUND]