What do you get when you combine a clinical psychologist with an asset manager? You get, Doctor Daniel Crosby, and the fascinating world of behavioural finance.

We’ve all probably poured over one of those monster lists of cognitive biases at one time or another. It’s interesting stuff, but isn’t much use unless you know what to do with it.

And of course we all think, “I’m far more rational than that.”

In Doctor Daniel Crosby’s latest book, The Laws of Wealth, he goes beyond the list and gives us some practical tools for managing our own and our client’s behaviours.

Daniel generously answered some questions about biases, breaking the rules, adviser education, adviser alpha, and rule-based behavioural investing.

Tell me a bit about you, your business, and what you do from day to day?

I have two primary roles; one as a consultant around financial behavior and the second as an asset manager.

My consulting work is through Brinker Capital’s Center for Outcomes, a program designed to help advisors become better at doing what they do best – manage investor behavior.

Studies from Vanguard, Morningstar, Aon Hewitt and others show that investors who work with advisors receive a 2 to 3% boost in annualized returns as a result of behavioral coaching. Of course, an advisors best advice is only as effective as it is influential to the client, so we help advisors become more persuasive.

On the asset management side, I incorporate the great body of research around decision-making into my stock selection at my firm, Nocturne Capital.

I am of the opinion that asset management is grossly over-engineered and fails to implement much of the extant behavioral finance research. So, if there is an overarching goal it is to help investors make and keep more money by adherence to sound psychological principles.

How did you get started working in behavioural finance?

I was originally a finance major in college but took a two-year break (after my Freshman year) to serve a mission for my church in Manila, Philippines. After two years of helping people turn their lives around and seeing lots of untreated mental illness, I thought that the best course for me would be to pursue a degree in psychology.

About halfway through grad school I was already getting stressed out by having to talk to people at the lowest points in their life and wanted more positivity in mine. I began to look for business applications of psychology that would combine my love of thinking about why people do what they do with a non-clinical setting. I’m the son of an advisor and so investment management was where I started and ended my search!

It’s pretty easy to find a list of behavioural biases, but knowing how to use that knowledge to prevent or minimise the impact, is tricky. Can you share some examples of how we can apply some of this knowledge in practice (with clients and with ourselves)?

The enumeration of the myriad ways in which we are irrational was a useful point for behavioral finance to break from traditional approaches, but it isn’t all that helpful in the moment.

For instance, we’ve now identified well over 100 ways in which we all make money mistakes but knowing that does very little to impact my decision-making day-to-day and it may actually harm me.

Part of what I did in The Laws of Wealth was to break down the existing universe of investor misbehavior into five fundamental pillars. There may be 117 different ways to get it wrong, but fundamentally they all load on to one of the five.

They are:

Ego – our tendency to think that we are special and the rules don’t apply to us
Emotion – the propensity to let affect drive decision-making
Conservation – a preference for the status quo and an aversion to loss
Attention – our tendency to be drawn in by the lurid rather than the probable
Information – limits to the way we discover and process information
Susie note: Here’s a snippet from The Laws of Wealth (p.65), sharing a practical example from the research. (And imagine if we put photos in Statements of Advice?)

“Consider the words of George Loewenstein: ‘The process of mentally bucketing money in multiple accounts is often combined with earmarking the accounts for specific goals. While it seems like an inconsequential process, earmarking can have a dramatic effect on retirement savings. Cheema Soman found that earmarking savings in an envelope labeled with a picture of a couple’s children nearly doubled the savings rate of very low income parents.’”

It’s common for people to think that biases apply more to other people than themselves. And advisers probably focus mostly on client behaviour, than their own. But no-one’s immune. Who do you think is responsible for more financial destruction – biases in clients, or professionals? Why?

I like to say that the less you think the lessons of behavioral finance apply to you, the more that they do. There is some research to suggest that fund managers and advisors are prone to they very same mistakes that retail investors are.

For example, fund managers consistently have their highest cash positions when stocks are the cheapest and have the best projected forward returns.

The difference seems to be that we are able to give others good advice even when we don’t follow it ourselves. So, even though an advisor might make all of the same mistakes in his own portfolio, he can keep you from doing it in a sort of “do as I say and not as I do” scenario.

In a way I kind of like how helpless we all are by ourselves because I guess it means that the members of the human family really need each other!

I write books and speak about these things daily and I still pay an advisor because I know that all of my knowledge is for naught when things get truly scary in the market.

Do you sometimes break your own rules? i.e. become a victim of your own biases, even though you know what’s good for you?

I’m actually struggling with a decision right now about whether to pay off my house or not. It would take a sizeable chunk out of my retirement savings to pay off my house and I know the sort of negative impact that would have on the ability of that money to compound.

On the other hand, it would just feel so good to have it taken care of, regardless of the fact that my expected returns in the market are much higher than the interest rate on my house. I haven’t made a move yet but it’s something I think about almost constantly. Not a very dramatic mistake, perhaps, but it’s where I’m at today.

Where can advisers learn more about behavioural finance?

The most affordable (and perhaps best) option is to start with some of the books on my list.

More and more we are seeing continuing education on the topic as well. IMCA has a formal program that is informative if rather dry and beyond that I think you’d be talking about graduate school.

I understand that Europe has a number of excellent MS degree programs in behavioral finance behavioral economics, but the US is sorely lacking in that regard.

I’ve said before that I hope one day that behavioral finance will be so deeply integrated into core courses that no distinction will be made between what is “behavioral finance” and “traditional finance.” Inasmuch as all finance is behavioral so why make the distinction?

Australia is currently undergoing reforms for the education of financial advisers. If you could design the course/qualification of your dreams, what would it look like?

Vanguard has a fantastic white paper out called, “Advisor’s Alpha” that speaks to where advisors add value. They show that advisors add about 300 bps of value per year and that behavioral coaching accounts for fully half of that. Nothing else an advisor does accounts for anything like 150 bps of value.

Any advisor education course that doesn’t have behavioral finance at its core is lacking and out of step with the research.

How does this all apply to active/passive investing? What do you see as the implications?

I invest in a manner that I alternately refer to as “rule-based behavioral investing” or “middle path investing.”

Part of what I take on in the book is what I see as the false dichotomy of active versus passive investing. What we refer to as “passive” investing is subject to human bias too inasmuch as the index itself is created by a committee who sometimes breaks their own rules to include growth names. Inasmuch as market cap indices are slanted toward growth, large market capitalization and expensive stocks, I think that we can do better.

On the other hand, what we refer to as “active” investing has problems as well. The sad truth is that nearly ¾ of active funds (so-called) are low conviction and don’t differ meaningfully from their benchmark. So, you’re getting high fees and no real differentiation, the worst of both worlds. Active funds also tend to overtrade and tactical funds are especially guilty of this.

Instead of engaging in a false discussion around what is active and what’s passive, I advocate investments that meet the following criteria – diversified, low turnover, moderate fee, and account for behavioral bias. Passive investing hits the first three points, but fails to capture the final point and that’s where I try to add value.

What book have you read that you’d recommend and why?

It’s a great question and one that I get asked so frequently that I actually prepared a list of my favorites. Of course, in a nod to overconfidence, my book is at the very top of the list.

Susie note: I’ve read Doctor Crosby’s book and think it’s a cracking read. It’s like a combo of Ariely and Kahnemann. Easy to read, lots of interesting examples and research, and deep in its ideas and application.

What piece of software or tool is integral to your day?

I use an online value investing portal called GuruFocus that has some of the obscure academic metrics that are a big part of my decision-making. Some of them are quite hard to find but the folks at GuruFocus do a great job of putting it all in one place.

If you weren’t a behavioural finance guy, what would you be doing?

I would be a writer. I’m never happier than when I’m writing, I only wish it paid a little better. I would love to write children’s books and think I might actually take a run at it now that I’ve written a few finance books.

Susie note: Daniel’s already written a kid’s book called Everyone You Love Will Die.

What’s the best way to find out more about you?

Website: Nocture Capital
Book: The Laws of Wealth – Amazon or Book Depository
Twitter: @danielcrosby