# The Behavioral Investor Author: [[Daniel Crosby]] ## Review The first two parts of the book described how psychology, sociology and physiology are related affect our ability to make decisions. In his view you can classify the investing mistakes we make into four categories: Ego, Conservatism, Attention and Emotion. Ego: The mind economizes on the intellect. It believes in narratives and seeks out information that confirms its prior beliefs (especially those confirming our own superiority) and is highly skeptical of information that runs counter to our beliefs. To overcome this be open minded about new information, have a learners mindset, be analytical about beliefs and accept that we are fallible. Create a system or process to uncover assumptions and to challenge your views. Risk is ultimately about the likelihood we are wrong, or unable to implement our intentions. Conservatism: We have a propensity to go with the status quo, which likely stems from loss aversion. We have more regret for outcomes that result from action than inaction and will bend our preferences to rationalize inaction. Create a system to avoid fear inducing situations and try to come up with measures of actual risk and reward that can be compared rather than letting the mind (and its biases) guide you. Attention: We are faced with too much information on a complex system, and believe in stories to help us make sense of it. Use simple models based on a combination of data and theory to make decisions. Emotion: Emotional situations distort the way we see the world, and physiology can impact our emotional state. Avoid emotion-inducing states and follow a model that you can relegate decision making to if those moments do occur. In short, we seek gains and want to avoid losses even more. Especially the loss of that which forms our identity: our beliefs. We need to recognize the impact this has on our psychology and create processes to prevent us from realizing these cognitive and behavioral shortfalls. I found the first three parts very useful but I am irked by his insistence that the human brain is not made for investing. I think that is most likely wrong and instead we just need to unlearn patterns of thought and behavior that prevent us from being good. There are some investors out there whose ability to let go of their ego, combined with their analytical rigor and detachment from narrative, make them great at investing. We can all be like this it just takes time and effort to (un)learn. The last part of the book describes an investment strategy that is coherent with his ideas on investor psychology from the first two parts. I enjoyed what he was trying to do because so far there are no practical frameworks from the behavioral finance school (that I know of - besides the list of do's and don'ts). I am sympathetic to his efforts because I am also trying to do the same thing - that's why I am reading his book! However, I don't agree with most his analysis and conclusions on how to manage portfolios or make investments. His framework is riddled with contradictions and ironically probably the result of his own psychology. He believes that active strategies should be concentrated and based on momentum or value. He also believes that you should be long most of the time unless momentum and value are absent. In effect he is saying these are the only two valid edges one can have in the market. To be clear, I agree that this are good strategies but they are clearly not the only ones. Just to give a counter example, Renaissance's models result in a portfolio that is not concentrated nor based on value or traditional momentum, and (from what I've heard) is likely based on exploiting investor behaviour. Is this not a sound investment strategy for the behavioral investor? I have thought about these issues a lot and in my opinion it comes down to: having models that give you an edge on the expected value of future outcomes vs expectations. The models are theoretically sound and based on data, but don't necessarily have to conform with some historical market data (e.g. if the event has never occurred before). Psychology comes into play in the analysis stage where our mind plays games with us, influencing and biasing the analysis towards our desires (e.g. to protect our ego, to avoid perceived loss, or towards perceived gains). We need to work to weed out assumptions and be honest about ourselves so that we have sound analysis. The analysis leads us to models that give us an edge, and it can be based on almost anything not just value or momentum. The first two parts of the book was incredible with respect to elucidating the impact of psychology. The last part on how to invest with behavior in mind was average. ## Key Ideas - we seek gains and want to avoid losses even more. Especially the loss of that which forms our identity: our beliefs. - Be rigorous about belief formation and let go of your ego to improve your ability to make decisions. - We need to recognize the impact biases and emotion have on our psychology and create processes to prevent us from realizing these cognitive and behavioral shortfalls. ## Related - [[Belief Formation]] - [[Letting go of your ego]]