To day to strength to day. If you could change only one thing that would help your investing, what would it be? The answer? Your own behavior. We humans are a mess of biases and poor decision making. We only read or watch things we agree with. We forget our worst trades, and we allow our emotions to get the best of us. We are filled with unjustified overconfidence in our own abilities. As it turns out, when it comes
to investing, we are our own worst enemies. I'm Barry Riddelts and on today's edition of At the Money, we're going to discuss how to best manage our own behavior for the health of our portfolios. To help us unpack all of this and what it means for your portfolio, let's bring in doctor William Bernstein. He is both a neurologist and a professional investor. He is the author of numerous books on investing, perhaps most famously The Four Pillars
of Investing Lessons for Building a Winning Portfolio. So Bill, let's start with a simple observation from your research. When it comes to making risk allocation decisions in capital markets, we just ain't built for it.
Explain well, Barry, our late places scene ancestors evolved in an environment with a risk horizon that was measured in seconds, sometimes fractions of a second, whereas in the modern era our financial risk arise and extends a half a century or so. So, in short, we are living in this space age with stone Age brains.
So let's delve into those stone Age brains and how its evolutionary development leads us Australia in modern capital markets. What is it that our wetwear does to us?
Well? My favorite analogy is what I call the skunk analogy, which is over the past ten or twenty million years, skunks of all a very effective strategy for dealing with large predators, which was to turn one hundred and eighty degrees, lift their tails, and spray. And that's very effective until they find themselves in a semi of environment where the biggest threat to their existence is a two ton hunk of steel moving at sixty miles an hour. That is
exactly the wrong strategy. It's the same way with investing. When we mess up and we want to distance ourselves from our mistakes, we panic and we sell, which most of the time is the wrong response.
I love this quote of yours to the extent you succeed in finance, you succeed by suppressing the limbic system, the very fast moving emotional system. If you cannot suppress that, you're going to die poor. Explain that to us.
Well, our system one, that is our crew be speaking. Our repilian brain is where our fear and our greed live. So to give you a simple example, we evolve to think well of ourselves and to feel shame and discussed when we fail, which is a very effective evolutionary strategy in the late place to seem environment. And unfortunately, when we make a mistake in investing, we buy a sinco asset, we try to distance ourselves from it by selling in
a panic. Now, the level of individual security is that may or may not be an effective response, but at the asset class level, it's generally best when you buy a bad acid class to either hold firm or to buy more.
So let's get into some more details about that you observe. The single most important determinant of one's long term success is one's behavior during the worst two percent of markets. Why is that, Well.
You can think of investing metaphorically as a highway on which you drive your assets from your present self to your future self, and most of the time the driving is pretty smooth, the road is pretty good. But occasionally they'll suddenly run into a massive pothole or a blind curve on a dangerous mountain pass with no guardrail, and
that's the worst two percent of the time. So in general, the slower you drive, that is, the more conservative your portfolio, the more likely you are to convey those assets from your present self to your future self, that is, to complete the journey. And the message there is to invest more conservatively than you think you should, because two percent of the time it'll prevent you from bailing from the very effective long term strategy.
So let's talk a little more about that two percent. I imagine the worst times for investor behavior is either at the very top of a bubble where people have a tendency to have pharmo and pile in, or at the very bottom of a market correction or crash, where people panic and capitulate and just dump everything of the lows. What's your experience been.
My experience is the bottoms. That's more important. When I talk about the worst two percent of the time, I'm talking about you know, two thousand and eight, two thousand and nine. I'm talking about nineteen seventy three, nineteen seventy four, or nineteen thirty one nineteen thirty two, if you're familiar with that history. Compounding is magic, but you have to observe Charlie Munger's prime directive of compounding, which is to never interrupt it. So that's what you're trying to prevent.
You're trying to prevent yourself from interrupting the magic of compounding. And you do that by paying attention to the worse two percent of the time and to design your portfolio with that worse two percent of the time in mind.
Very interesting. So let's talk about one of the other issues that overconfidence seems to lead to, and that's glamor stocks. People seem to be seduced by these. It used to be Amazon, then it was Apple, then Tesla, today it's Nvidia. Why are we so taken by these household names that have had tremendous run ups in the market.
Well, the economic historian Charlie Kindelberger said it best about a half century ago, which is, there's nothing so disturbing to one's well being in judgment as to see a friend get rich. And that's the problem with glamor stocks. Put another way, the history of stocks, the stocks of companies with revolutionary technologies that sell it stratospheric multiples. It's not unhappy history. Generally you wind up not doing terribly well when you do that.
Another quote of yours that I love, the advent of free trading is like giving chainsaws to toddlers.
Explain well, in the first place, commission free trading can be an advantage, just like a chainsaw can be a marvelous tool if you use it properly. So how do you use the chainsaw of free trading and low expenses effectively and safely? Well you do it by buying and holding low cost EPs an index funds. How do you use free trading improperly like a toddler with a chainsaw, Well, you trade stocks and even worse options all day long.
If you're trading options all day long on a free platform, your wealth is going to melt like Iceland a hot pavement.
So let's talk a little bit about that over confidence. Do most of us really believe we're smarter than the market. Do we really think we're stock picking or market timing geniuses?
Yeah, we sure as heck do that whenever you trade a stock, you're saying you're smarter than the person on the other side of the trade, which is generally not true. And when you think that you can time the market, you're saying that you're smarter than the collected wisdom of the market, which is not true. You know more than ninety percent of the time. And if that's not over confidence,
I don't know what is. But there's an overconfidence that's even worse than the overconfidence of stock picking and market timing,
and that's over confidence about your risk tolerance. At the top of the market, everyone's a long term investor, and they don't take to heart my favorite quote from Fred Schweed's marvelous book, Where the Customer's Yachts, which is that there are certain things that cannot be adequately explained to a virgin, either by words or pictures, Nor can any description I might offer here even approximately what it feels like to lose a real chunk of money that you
use to own. And that's what you run into when you're overconfident about your ability to tolerate risk.
To say the very least. So there are a couple of other things in some of your books that really stood out when it came to human psychology, and one of the things that jumped out was, very often we rely on conventional wisdom. When the conventional wisdom is very often wrong. How does conventional wisdom lead us astray?
Well, the conventional wisdom at a general sense is very often right. Conventional conventional market wisdom that you need to diversify to keep your expenses down, and there's a connection between risk and return. Those are all generally true. But where conventional wisdom falls down is when it comes to specific securities. And that's for one simple reason. The more favorably disposed the investing public is to a given stocklet say, the more its price has been driven up, and so
the lower its future expected returns. Now, the converse is true of universally reviled assets. The time to own junk bonds, for example, is when the term becomes an epithet that's spat out of the speaker's mouth.
One of my favorite Twitter accounts is called TikTok Investors, and this person pulls the most ridiculous investing strategies from TikTok and shares them. And the one I saw this morning was this woman who uses tarot cards to help her select option trades, and you could tell by her demeanor she really believes that this is useful and going to be a long term win.
Yeah. One of my favorite quotes from Larry Thummers. It's a short and pithy one, which is there are idiots look around.
So our final two questions, how can we overcome psychological biases to make better and more rational investment decisions?
Well, first of all, you trade as little as possible, and secondly, you sort of psychologically internalize the Tobin separation theorem, which basically separates out acid classes by how much risk they have. And so in the Tobin separation theorem, there are only two acid classes. There's the risky one, which is stocks, which has high returns, and there's the safe one, which has low returns. And so the key thing is
to cleanly separate those two things in your mind. And you do that by making sure that your riskless apps, riskless assets really are riskless. And you know, when the experiment hits, the ventilating the system, corporates and even municipal bonds are going to make you take a haircut on those holdings if you want to use them to buy
cheap stocks or simply to pay for your groceries. Another way of saying that is there's a reason why Warren Buffett keeps twenty percent of Berkshire in t bills and cash equivalents.
Sounds like you're describing the sixty forty portfolio.
There's nothing wrong with the sixty forty portfolio. You know, once every couple of years you'll see a headline that the sixty forty portfolio is dead. And you know, I think that anybody who says that needs to wear a sandwich board that says I don't know what I'm talking about.
Yeah, the last time that was said was right before a pretty substantial move down inequities, although to be fair, there was a modest move down in bonds as well. Our final question, how best should we manage our own investment behavior?
Well, there's, as we alluded to earlier, there's system one, which is your you know, your emotional reptilian brain. And there's system two, which is your inner mister spock, your logical internal processes. And the trick is to train your system to your logical system, to listen to your system one and to learn when it's acting up. And I've I've found, for example, that the most profitable purchases I've made have been accomplished when I felt like I was about to thrill up.
I know the feeling, so to wrap up. Overcoming our own psychology and making rational decisions is the key to long term success in the markets. Avoid trying to pick glamour stocks, avoid market timing, and most important of all, avoid giving in to your emotions when things get dangerous. Stay with your financial plan, invest for the long term, and you'll be fine. I'm Barry Redults and this is Bloomberg's At the Money