Bridge over ocean
1 October 2015 Multimedia

Greed and Fear of the Crowd

  1. Daniel Crosby

Dr. Crosby is a behavioral finance expert who constructed the "irrationality index" to gauge greed and fear in the marketplace. What better metric to describe the current investment landscape? Dr. Crosby will delve into how investor sentiment has become dislocated from fundamental value and how the combined wisdom of a crowd of individuals is different than the pitfalls of following the crowd.

This is an archived recording of a live broadcast that took place on 1 October 2015.

DANIEL SPENCER: Now, we'll get right into our next session. I'd like to take a moment to just let our audience from around the world who's now joining us remotely via the CFA Institute website-- those online, please use the online chat area to connect with other viewers and enter questions for the speaker.

For our live audience room, please continue to use the Lintella site, or there's actually some paper on your desks if you'd like to ask a question there. And put your hand up. We'll have someone come pick it up.

Thank you all for participating in this morning's live session. My name is Daniel Spencer. I'm currently vice president of the CFA Society Calgary, and I'll be this session's facilitator. Without further ado, I'll introduce our speaker.

Educated at Brigham Young and Emory Universities, Dr. Daniel Crosby is a psychologist and behavioral finance expert who helps organizations understand the intersections of mind and markets. Dr. Crosby recently coauthored a New York Times bestselling book entitled Personal Benchmark: Integrating Behavioral Finance and Investment Management.

He also constructed the Irrationality Index, a sentiment measure that gauges greed and fear in the marketplace from month to month. His ideas have appeared in the Huffington Post and Risk Management Magazine, as well as monthly columns for and Investment News. Daniel was named one of the top thinkers to watch by and a financial blogger you should be reading by AARP.

When he is not consulting around market psychology, Daniel enjoys independent films, fanatically following the St. Louis Cardinals baseball, and spending time with his wife and two children. Ladies and gentlemen, please welcome Daniel Crosby.


DANIEL CROSBY: Thank you, everyone, and good morning. It is my sincere hope and prayer that you are not following the US presidential election right now. But in the event that you are, you may have heard Donald Trump's recent comments about building a wall along the border with Mexico. You then may have seen him one-upped by one of the people running against him, who suggested that not only should we build a wall with Mexico, but that also, we should build a wall with our northern neighbor of Canada.

At the time, I suggested online that all we would do by walling off Canada is block off the States from really friendly people, great food, and reasonable government. And that has absolutely been the case, as I've spent some time here. So thank you for having me, and it's an honor to be here.

I want to begin-- continue my efforts at kissing up to you and complimenting your great nation. Well, I mentioned the Blue Jays clenching yesterday as a segue to talk about a baseball story. A baseball story that's told by Paul DePodesta who at one time worked in the front office of the LA Dodgers and has worked at other places around Major League Baseball.

Paul DePodesta relates the following story. He relates the story of being at a casino with a friend, and that he and his friend were playing blackjack, and that his friend had a 19. His friend is showing 19. The dealer is showing 10. And his friend decides to hit. His friend asks for another card.

DePodesta says, whoa, whoa, whoa. Maybe you've had too much to drink. Think about this. Think about your odds here. This isn't a great idea. And the friend goes, no, no, no. He waves him off, and he says, no, hit me. Hit me! The dealer turns over a 2, and the friend begins celebrating. The dealer ends up with a 20. The friend, of course, has a blackjack, and wins a handsome sum of money.

Paul DePodesta's friend then begins to rub it in his face-- hey, if I had listened to you, I would have lost that money, and I would have been wrong. And DePodesta makes a point that I want to make here today, which is that you can be right and still be a moron.

And so we're going to learn some basic pillars today, some basic principles. They won't always be right. The strange trajectory, the vagaries of the financial markets, won't always align with our principles moment to moment. But I tell you with great confidence that if we do these things over time, if we maintain the long-term focus that was discussed in our first presentation, I bet you'll come out a winner over time, because you can get it right and still be a moron.

I want to talk-- I travel a lot for work. I was recently in Omaha, Nebraska. And I'm from the southeastern United States. I'm from the Deep South. And I don't know how familiar you are with the caricature of that area, but in the Deep South, we have a reputation for being very-- lots of things, but very friendly, for one. We're very chatty. We're very friendly. And I try and live up to that.

So I was recently at a bar in Omaha, Nebraska, and waiting for a cab to come pick me up and take me back to my hotel. And I chatted up a gentleman that was sitting next to me at the bar who was clearly annoyed that I was talking to him. Well, this only incited me further, and I just wanted to be that much friendlier and that much more annoying to him. And I started talking.

And so finally, he says to me, perfunctorily, OK, yes, where are you from? What do you do? These get-to-know-you questions. I tell them I'm from Atlanta, and I tell him I am a stock market psychologist. And this deer farmer's head nearly exploded, because this was the most bogus and useless profession that he had ever heard of. And I think sometimes my parents feel the same way. And so he said, so let me get this straight. You go around the country and tell people to buy low and sell high? And I said, yeah, something like that.

So it's very easy on paper. We've all seen charts like this of market sentiment that would suggest when you look at something like this-- hey, it's real easy on paper. You ride up periods of market euphoria. You get out when things start to get a little bit troublesome. And then you buy again during periods of despondency. But we know from our experience that this is tough.

We know that this is tough for a couple of reasons-- foremost among them, that insanity never feels that way in the moment. I mean, it's easy for us to look at a chart like this and say, with 20/20 hindsight, yeah, things were a little frothy then, or maybe people were a little bit overly negative at that time. But at the moment, it feels genuinely exciting or genuinely negative.

So I wanted to create something as my primary research interest that takes the subjectivity out of this. And I created the Irrationality Index that was mentioned in the introduction. The Irrationality Index, which I'll refer to as the NOISI-- the Nocturne Investor Sentiment Index-- the Irrationality Index was put together using what's called principal component analysis, which is a statistical procedure whereby you regress a number of variables against, in this case, medium-term stock market performance.

I wanted to take out qualitative measures altogether. It's a great frustration of mine that so much of what passes for consumer sentiment measures, or stock market sentiment measures, are qualitative, very subjective, and survey-based. If you know much about people, you would know that people are very, very awful predictors of their own behavior. And we have a very limited ability to even talk about how we feel. So I wanted this to be based on data points and not surveys.

So I originally began with-- I believe it was 25 different variables. And most of them, frankly, were not all that predictive of anything much. So in the final analysis, we boiled it down to seven variables that commonly load on to what we call sentiment that have some decent predictive power with respect to future market moves. I won't tell you all the specifics, or I'd have to kill you. But suffice it to say, it's momentum, it's volatility, it's valuations, it's yield curves. All of these things play a big role in predicting future market moves with respect to market sentiment.

So I went back in time. This has been back-tested to the early '90s, which is when the data that we need comes to fruition. Whoa. Excuse-- can we get that? There we go. Thank you. So this starts in '93 and goes up to the current day, of course. And I looked back at some highs and lows in the market just to give you a sense of how the Investor Sentiment Index is calibrated.

If we look at a high in March of 2000-- and this is for the US stock market, this is for the S&P. If we look at March of 2000, the Investor Sentiment Index sits at 84, which I've classified as a period of mania. It's broken up into quintiles, and so the top quintile is what I refer to as mania. I'll look back a couple of years forward. It has significant crash, and it's all the way down to 34. Again, in June of 2007, it's signaling, again, that we're in a period of mania. And then, of course, in March of 2009, it got all the way down to 11. It spent some time around 5. That was the absolute low that it's ever been.

Now, earlier this year, we were once again at 84, which I classified as a period of mania. Now, I got some push back in the press when I would publish these results, because people referred to this as the most hated bull market of all time. And indeed, it was in a lot of respects. But I think data speaks louder than anything else, and that your intentions or your attitudes about something don't speak as loudly as your behavior. So I still classify this as a period of mania. Even if no one was especially manic about it, all the data points pointed to this.

So now I'm going to flip it over to my folks over here, my tech geniuses over here. And I'm going to ask you to vote on where you think it sits today. At the beginning of this year, it was in the mid-'80s. I want you to vote on where you think it is today. Just a guess. I've given you four bands here. 80 to 90, 70 to 80, with 100 representing absolute greed, and 0 representing absolute fear. This is cool.

All right. Can we throw those results up? OK. So we've got, it looks like about half of you think it's 60 to 70, about another quarter think it's 50 to 60. Survey says-- can you go back to my controls, please? There we go. As of last week, when I had to put this all together, we currently sit at the 56th percentile. So as you might have guessed, we're dropping pretty rapidly. I mean, this is a pretty enormous drop in a pretty short period of time, all the way from the recent high of 84%.

So what does this mean? Well, one of the things that I like about the Investor Sentiment Index is that it allows us to make a mathematical, a model-based estimate of what forward returns are going to look like. In this case, we're looking at three-year, medium-term returns.

Now, all things being equal, which of course they never will be, the current level of irrationality suggests that we're going to realize US market returns of about negative 2.2% annualized over the next three years. Womp, womp. Right? Not great news. Some rain clouds there that we talked about in our earlier presentation.

But this isn't the only thing that I think points in that direction. A second research interest area of mine is in value investing. And one of the things that I like to do, or a frustration of mine, rather, is that you'll hear talking heads come on CNBC or whatever other channel and say, usually within the space of an hour, the market is fairly valued or the market's steeply valued, oh, it's a great time to buy.

And I got frustrated with this, again. Felt very, very subjective to me. And so I said, I'm going to take a handful, five of the most widely used measures to measure broad market valuations. I'm going to convert them to percentile ranks, and I'm going to average them to say, trying to overcome the individual weaknesses of any given model, but to say, big-picture, where is the market at?

So I back tested this to 1971. Again, that 80% and above is going to represent a period of what I'm going to call mania in terms of market valuations. And indeed, three separate times since 1971 has this crept over 80% on a rolling three-month basis. Those three times were August of 1997, where it got over 80 and then stayed over 80 for a couple of years, until it fell dramatically, November of 2007, and then again this year, in January of 2015. So currently, we're down about 7% in terms of the percentile ranks on this valuation metric, and we sit at the 78th percentile.

Mean reversion being what it is and being a concept that I truly believe in, we can expect to pay for periods of great returns with periods of somewhat lesser returns. So the five-year estimate using this composite valuation, our metric says that we're going to get, again-- womp womp, about negative 1.1% a year over the next five years, is where I estimate that to be given the current levels of market valuation.

Now, because we've had a-- whatever it is now, 10% to 12% contraction in the US market, a lot of times you will hear people on TV saying, now is a great time to buy. It's a great time to buy. Things have never been better. I think it's always a great time to invest, in one respect. I don't believe in market timing in any real significant sense. But it's hard to say that stocks are cheap right now. I don't think there's any way that you could look at these numbers and say, even today, after a pretty significant drop, that something like the S&P sits at a very attractive valuation. It's still right toward the top of that historical valuation.

But I'm not alone in this. Jeremy Grantham released this a couple of months ago. It's old, so granted, these are going to be a little better, assuming that-- factoring in the crash that we've had, the drop that we've had. But you see his predictions here. He has us going out and all buying a lot of timber. But his predictions for the next seven years, US large cap down about 2.4% a year, are fairly consistent with what you saw from my model.

And we are on pace for this to be the first year since 1990 where cash will beat not only stocks, but bonds as well. There's really been nowhere to hide of late. This is, again, a couple of weeks old. You'll see that the stock numbers have changed pretty dramatically since then. But you see, basically, there's nowhere to hide. There's been nowhere to hide of late, and it's tough to know what to do.

So this is all kind of a bummer, and you didn't bring me out here to give you strictly bad news. So I feel like I have some good news for this crowd now, which will be delivered by Star Wars hero-- delivered by Princess Leia-- which is active management. You're my only hope. Active management is the one bright hope for all of this. Beta is going to suck for the next five to seven years. It will be awful. And active management is the bright hope of the next three, five, seven years.

But if history is any predictor, active management will probably let us down as well. And the reason that active management will let us down if we don't make some serious changes is because, just like the first presentation, we sit at a crossroads here. You look at the returns on active management here. This is the percentage of active managers that are beaten by a passive index at the various years you see there. One, three, five, and 10. So at the one-year mark, 87% of active managers were beat by a passive index.

So we say, OK, that's short-term. Don't be short-term. We kick it out to 10 years, and we're still-- almost 80% of the time, active management is losing to passive management. Why is this? Well, maybe it's because large cap domestic equities are very, very efficient. It's tough to beat them. So let's look at small caps. It's worse. If we look at small caps 10 years on, 88% of small cap managers, active managers, are beaten by an equity index of small caps.

What are we going to do about this? What explains this? Why is it that the folks in this room, people like me and you, can't take all that we know, and all of our fancy letters behind our name, and do a little better than this? Well, we can, but we have to overcome three behavioral sins. Active management and active managers are prone to a couple of predictable scenarios that we're going to talk about today. The three that we'll touch on today are overdiversification, overthinking, and overconfidence.

So I've given you some bad news, and now I'm going to throw tomatoes at diversification. So we're off to a great start here, right? I'm not throwing tomatoes at diversification. I just want to think about it in a more nuanced way. Recently in my hometown of Atlanta, I met with a gentleman who reached out to me on LinkedIn. And he said, hey, could we have lunch? I run a behavioral finance hedge fund. And I said, cool. I want to know what constitutes a behavioral finance hedge fund, so let's do it.

So we go out to lunch, and I sit down with him, and he starts explaining his strategy to me. And he explained that at any given time, they hold between one and eight stocks. And I said to him, I'm going to stop you there, because you do not have a behavioral finance hedge fund, and I want you to stop taking the name of my discipline in vain, because you are falling prey to the greatest behavioral sin of all, which is overconfidence.

He currently had two holdings. That's bananas. That's ridiculous. . And anyone who's giving him their money is going to be in for a world of hurt. Because we need to protect against hubris. We need to protect against overconfidence, which, as we'll demonstrate later, is a very real, human trait. So we have to be careful, because too few holdings, too little diversification, is overconfidence. It's hubris. It's an unrealistic belief in our own skill. But as was discussed in the first presentation regulators are cracking down on closet benchmarking. So too many holdings or too great diversification means that we're not doing our job either.

So where is that sweet spot? Well, if we're talking in terms of random selection, and we're talking in terms of equities, again, it takes a lot fewer than most people realize. Again, going back to the atrocious US election right now, when you see these polls released, there's 300 and something million people in America. And yet, they will release polls of 50 and 60 people that are absolutely representative of the national attitude.

Because when you're random sampling, it doesn't take that many to get a truly representative sample that rules out or largely rules out idiosyncratic risk. You see here that with even just 16 stocks, you take care of over 90% of idiosyncratic risk. So we can afford to be a little higher conviction and still be appropriately diversified.

So much of what accounts-- so much of what is called active management these days-- is simply not. And this is what accounts for the gross under-performance that we saw earlier. It's passive in active clothing. And it's a disservice to you. It's a disservice to your clients. And it's a shame that we've all spent so much time learning all this great stuff about financial markets that we're not bringing to bear.

A mere 8% of ETFs are high conviction, which maybe we'd expect, because a lot of ETFs are just going to mirror an index. But look at this. 23% of mutual funds are considered active management and differ meaningfully from a benchmark. That's pathetic. And that means that 77% of mutual funds are overpriced index funds.

The other thing that I would call on us to change is that the more active a fund becomes, the more expensive it becomes. Whereas theoretically, you could keep better track with less time, less resources, and more economically keep tabs on fewer holdings. But the average expense ratio of one of these 23% of mutual funds that is actually active is quite a bit higher than average. So there's a couple of problems happening here.

Why does this happen? I think the reason that it happens is because-- largely, it owes to career risk. I think it largely owes to career risk, and I think it largely owes to mistaken notions of what constitutes risk. Risk is not volatility. Risk is not tracking error. Risk is absolute loss of capital. And when we begin to think about risk in the way that Ben Graham and others thought about risk, we're able to have healthier notions of what constitutes risk and were better able to help our clients.

I love James Montier's comment here about, looking at tracking error is like sending a boxer into the ring and saying, go win, but not by much. I just sat through a due diligence presentation earlier this week in which a manager simultaneously touted his ability. To achieve alpha and differentiate almost not at all from a benchmark. It's silly, and it's nonsensical.

On Active Management Works, there's a robust discussion right now around active share that I would encourage you all to dig into and engage in. But the fact is, right now, holdings portfolios that differ meaningfully from benchmarks do much better from those that do not. You see here active share by quintiles. And you see, very predictably, the highest quintile outperforms indexes by about 1.2%. The lowest quintile under-performs by about 1.5%.

We know what we're doing. All this schooling you went to, all the CFA, all these great designations-- they've taught you wonderful things. But we need to put ourselves in a position to apply these wonderful things in a concentrated enough dose that our clients are able to achieve that benefit.

An asset manager I'd encourage you to check out, who really does have a behavioral approach is a gentleman by the name of Tom Howard. Tom Howard is a firm believer in active management, and his research found that the top holdings of active managers outperformed by 6% a year. The top holdings, their highest-conviction holdings. So why is it that when the top holdings of active managers are outperforming, that active managers writ large are underperforming dramatically?

Well, it's all the other stuff. It's all the low-conviction stuff that's tacked onto the end. We know what we're doing. Stock picking is a real thing. But you have to do it in concentrated enough doses to get the benefits of active management. And to do so takes risk. It takes career risk. It takes bravery. But we have to demand that we are able to do our jobs in the way that best serves our clients.

Part two. We're going to talk about the virtues of laziness. The virtues of laziness, or why your clients would be better off if you went to work one day per quarter. Bring this back to your boss. Boss, we'd be better off if we worked four days a year.

I don't know about soccer-- how soccer lives in Canada. I imagine that it's a much bigger deal here than it is in the US. It could scarcely be a smaller deal than it is in the US. But a couple of years ago during the World Cup, the US-- even the US, who usually is pretty indifferent about soccer-- really got into it.

So we got into soccer for just a couple of months and then we forgot about it entirely again, as we're wont to do. But during this time, I read some great research on the psychology of soccer. And I read about goalies in particular. And there's a fantastic study. And I want you to think about it. I want you to put yourself in the mind and heart of that goalkeeper.

So you're the goalie for Canada's national team, and someone from the US or whatever country is driving toward you. They got a one-on-one. They have a breakaway with you, and they're about to take a shot on goal. Simply put, you have one of three options. You have one of three options. You can dive dramatically to the left, you can dive dramatically to the right, or you can stay right where you are, in the middle.

Leaving aside our fancy technology and going back to the good old days of raising hands. Raise your hand if you would dive dramatically to the left. Nobody? Dramatically to the right. Staying in the center. OK. You read the report, too. So all the research says that 94% of the time, goalies dove dramatically to the left or to the right. 94% of the time, they'd make some huge, sweeping action to try and save the day.

And it's very intuitive why they would do this. There's a billion people or whatever watching you. You're on international TV. It's just you and this other person, and they're going to kick it at you, and what? You're going to stand there like a doofus? No, you're going to give it your all. You're going to go down swinging if you go down. But what did the research find? We stop so many more goals when you just stand there. When you just stand there and let it come to you.

And so they taught the goalies this. And this tells us why behavioral finance is such a tough thing, behavioral economics. They tell the goalies this. Of course they educate them on this, and they say, hey guys, if you just chill, if you just chill here in the middle, you're going to do a lot better. And nothing changed. Because still, at the end of the day, you don't want to look dumb when your country's future is on the line. And the parallels I think to our lives are startlingly similar.

There are a couple of ways in which investment management differs dramatically from every other pursuit in life. I wanted you to look at this chart, which broke up trading activity into quintiles again. We've got everyone from the extremely patient low-turnover trader to the extremely hyperactive trader. And that last line, that left lighter blue bar, shows performance. So whether you were doing nothing or lots of something, the performance is essentially the same.

Think about another place in life where you could work and work and work and try and get nothing out of it. If you run more, you lose more weight, you get to be a better runner. If you read more books, you become a smarter person. If you trade more, you get absolutely nothing but fees. That line on the right talks about the absolute performance, the performance adjusted for fees and trading costs. And we see that hyperactivity does nothing to help us, and everything to rack up fees and penalties.

Another study done by Barber and Odean came to an even more damning conclusion. They divided them into five groups as well, and found that you sacrificed about a third of your returns by over-trading. And they found that this was especially problematic for one certain group, and that would be the guys. The guys were especially bad about this.

And a friend of mine wrote a book called Warren Buffett Invests Like a Girl, and So Should You. And she talks about all of the ways in which women tend to be better investors, more patient, have more realistic probability curves, and in general just make better decisions. And it's all behavioral stuff. Single men trade 67% more than single women, and men trade 45% more than women and again end up costing themselves more than 2 and 1/2% a year. I mean, 2 and 1/2% a year is dramatic.

If you look at that over an investment lifetime, we see that patience is warranted, and that a lot of times our best efforts are not really rewarded past a certain point. This coincides with a recent study of Taiwanese day traders that found that intraday traders in Taiwan, only one in 360 of them showed any skill. And a lot of that is because they were leaving on the table one of their greatest assets, which is time and patience.

Similarly a study done by Fidelity-- that's a little New Jersey English there on top-- a study done by Fidelity found something similar. They wanted to examine the behavior of their best and brightest. So they looked at their retail accounts that had done the best and they said, we're going to tease out the common denominators. What's common to all these bright, exceptional traders? What are they doing so well?

So they rounded up these best accounts, and they called them, and what do you think the commonality was? When Fidelity called them, they said, oh, man, I forgot about that account. I totally forgot I had an account with Fidelity. Thanks for reminding me. They had totally forgotten it. They had left it alone. Once again we see that patient behavioral management leads to what I call behavioral alpha, or outperformance due to behavioral characteristics.

William Sharpe has some statistics here that I'm sure you've all heard about. But I want to close out this section by encouraging you to follow the sage wisdom of Winnie the Pooh, which is also the unofficial motto of my home state of Alabama, which is, never underestimate the power of doing absolutely nothing.

The third pillar we're going to talk about here the third season of active management is overconfidence. Now I was mentioned before that I have written a book. I wrote a book on goals-based investing, which was a New York Times bestseller, and I'm very proud of that book.

But before that book, I had to learn my lesson on writing two other books. I wrote a book called You're Not That Great and it was based on a TED Talk I had given about seven counterintuitive truths for living a happy life. That book was not a New York Times bestseller, and people told me they found it very hard to gift. But not withstanding, I would still submit to you that you're not that great, and we need to be wary of the perils of overconfidence.

Leaving aside again our fancy technology, I want you to do something with me. Just roll with me here. I want you to close your eyes. And I can see you here. I will come down and rain down justice on you if you don't close your eyes. Close your eyes. I want you to close your eyes. I'm going to ask you a series of questions. You knew when you invited a shrink, it was going to get weird, so here we are.

The first question is, I want you to raise your hand if you think you are better-looking than average. All right. I'm taking pictures now. Just kidding. I want you to raise your hand now if you think you have a better sense of humor than average. Raise your hand if you are smarter than average. Now raise your hand if you think you are a better investor than average. OK. I see some liars in the audience, but we're going to let it go. Open your eyes.

So I think most of you are being humble or shy, or something. But in general, when these questions are asked of the general populace, you end up getting an answer something about 85% to most of these questions. So about 85% of people think they're better-looking than average. Every guy in the world thinks he's two sit-ups away from dating a supermodel. Everyone thinks they're funnier than average. People tend to think they're smarter than average. And then this goes over into investment decision-making as well. We tend to think we're better than average.

Now, why is this problematic, and which ones did you find hard? I think if you're like me, some of these are easier to let go of than others. It's not hard for me to say, yeah, I'm not better-looking than average. Not much I can do about that. Ugly is forever. But I will be damned if you will let me-- if you will say to me that I'm not as smart as average. The more volitional control we have over some of these things, I think, the more central they become to our self-esteem and to our personality.

But that pride can get problematic. Because what we tend to think of, in investment decision-making as in elsewhere, is that anything we get our hands on is going to be improved by that process, because we are so smart and funny and good-looking. But a lot of times in the investment world, as in elsewhere, more information can actually lead to worse decision-making.

So I want you to consider the following. Given this experiment broken into two groups, Group A was told, you have to approve or deny a mortgage application. You have a recent college grad who has a middle-class job with maybe some room for upward mobility. But you also are alerted to the fact that this individual has $5,000 in debt that they haven't paid over the last three months. So hold that to the side. Do you approve or deny this person for a mortgage?

Now Group B was presented with an entirely similar, except for one respect, option. They're presented with-- recent college grad, stable job, but they either have $5,000 or $10,000 that they haven't paid, and you have to do a little digging. You have to call around a little bit. You've got to do a little work. You've got to make a few phone calls, and then you're going to find out it's either a $5,000 or $10,000 bill that they don't have, and you'll figure that out.

In the first group, 71% of people turned this individual down, because they said, you know what? They're presented with all the information outright. They say this $5,000 bill, this recent lack of payment-- it's a bad sign. We're going to deny your loans. 71%. The second group-- think about it. The second group had equal or worse debt problems that were presented to them, but only 24% of them denied the mortgage application.

Why is it? Because they had gotten their talented little paws on the problem. They had intervened. They had made some phone calls. They had talked to people. And we want to be positive about something we've put some effort into. We think that if we've looked into it, it's going to work out, even if the debt is worse. Pretty interesting.

Information also leads to base rate ignorance. If you've not read Daniel Kahneman's book Thinking, Fast and Slow, I would recommend it to everyone as essential reading in the world of behavioral economics. And base rate ignorance-- here he talks about a woman named Linda. It says, Linda's 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination, social justice, and participated in anti-nuclear demonstrations. So based on this description, which is more likely. A, Linda is a bank teller, or B, Linda is a bank teller and is active in the feminist movement?

You're all chuckling, because you're smart, and you get it. You understand that the universe of feminist, socially active bank tellers is smaller than the universe of just bank tellers, and so you understand which is the right answer. But most people-- over 80% of people-- answer this question incorrectly, because they get so much information that they tend to look at the wrong stuff. This is why active management is most effective when it is highly, highly process-driven. Processes beat people again and again and again.

It's true in trying to determine prison recidivism. Parole boards try to determine whether prisoners will commit crimes again. They convene large, intellectual groups of smart folks with PhDs, and they say, sit down with his prisoner and see if he's going to come back here in five years, if he's going to do it again. 6% of the time-- 6% correlation between their recommendations and recidivism. If they just look at three things-- if they just look at the nature of the crime, the number of violations, and how they acted in prison, they quadruple the efficacy of that decision-making process.

Yeah, yeah, but that's bank tellers and that's prisons, and that's not investment management. But the same rules apply here. There's a robust body of literature on information processing and investment decision making that shows the very same thing. Once you have a couple of basics, you are not benefited by a glut of information on top of that. What happens, though, is that more information tends to lead to greater confidence. As you gather all this information, you get more confident about your assertions. You take riskier bets and sometimes lose some of the good things that we talked about earlier with diversification.

Joel Greenblatt, billionaire hedge fund, guru genius guy who wrote the Magic Formula book, found this when he applied this to his magic formula investing. He had a website that would give people a printout of his top picks based on the return on invested capital and the price of the stock. He would generate 25 or 50 top picks, then would give people the option-- do you just want to buy these? Do you want to just have us buy these 25 recommendations straight up, or do you want to cherry pick in and out the ones that you like and don't like, have some discretion?

Over the period of this experiment-- it was a couple of years-- his picks returned 84%. The benchmark returned 63%. The people that were cherry-picking his picks got 59%. Because there's always a reason that it looks ugly. A meta-analysis of process versus discretion turns up something very similar. Models beat or equal experts 94% of the time, and a paltry 6% of the time do experts beat the model. If your decisions are not at least very much guided by some systems and rules that keep your biases in check, you are doing your investors, your clients a great, great disservice.

So often-- I'm going to pick on CFA societies, my home CFA society in particular. Maybe all of them do this. I know the Atlanta CFA Society does every year-- a big prediction breakfast. And I watched the prediction breakfast from January of this year earlier, and I just laughed my head off, because we cannot base things on a thesis or a story or a forecast. We have to base our assumptions on models and systems and structures.

A gentleman named Philip Tetlock out of UCLA did a study where he studied expert decision-making, expert forecasting. He found a couple of fascinating things. He found the more famous the expert was, the more well-heard-of they were, the worse their predictions tended to be. The more bold their past predictions, the worse their future predictions tended to be, and that when he gave them feedback on-- hey, you may want to tone it down a bit and be a little more tentative or rules-based when making your predictions, they laughed him off and said one of two things. I was early. I was early, which we've all heard and loved. I was early, or my prediction fundamentally moved the market.

So what good are we, then? Are we to be taken over by robots? No. We are good for many things. We're good at building systems. We're good at assessing systems. We are good at researching and putting this all together. All of this is human-led, human-built. But it has to be governed by tight strictures and tight guardrails when we are implementing those systems, because it's our natural human tendency to want to override these. We have to slavishly follow the model.

So I'm going to have to hurry up a little bit here. As we begin to close up today, I want to just reinforce to you a couple of things that I've already said. Based on my models-- which are not based on any brilliant thesis I have, but just based on good sound reasoning over history-- I think that we're in for a tough medium-term. I don't know that there is any great reason to hope for a bull market in the next two to three years that isn't wholly due to animal spirits. That's the only thing that I could see pushing it.

So we have to bring to bear active management. But we have to bring to bear the right kind of active management, that's built with behavioral alpha. It needs to be diversified enough to be humble, but concentrated enough to showcase what we know and what we do so well. It needs to be systematic, to help us to avoid bias. It needs to be tax-efficient. It needs to be affordable. It needs to be infrequently traded to avoid our over-activity and our hyperactivity. And it needs to be forecast-free. It doesn't need to be based on some brilliant thesis about Greece or some story about what's going to happen in China. It needs to be based on mathematical logic and reasoning.

And then finally, I want to encourage everyone. We've talked all day long about asset management, and I've left out an even bigger piece. The even bigger piece is that we have to create products and advice systems that manage our clients behavior. Robo-advisors are not taking anyone's job anytime soon. And the reason is because the greatest value that financial professionals add to the lives of their clients is in managing their behavior.

Aon Hewitt found that those who work with financial professionals did 2% to 3% better per year than those who went it alone. Vanguard found that those who worked with financial professionals did 3% better per year than those who went it alone. Vanguard broke it down by the specific activities and found that 150 basis points of that outperformance owed to behavioral coaching and behavioral management, whereas a scant 35 basis points of that was down to asset management.

So we need to be managing our clients' assets in a way that's consistent with best behavioral practices. But even more importantly, we need to be engaging in the hand-holding and creating goals-based products that help them envision the life that they have always wanted to lead. Thank you so much for your time today and for letting me share these thoughts with you. Thank you so much.


I know I went over. Do we still have time for questions? Oh, that's a bad sign. Do we-- that's a bad sign. Wrap it up, or questions? OK, so here's a question from Charlie. Is it possible to get a copy of the presentation? Yes, sure.

Disagree with his point that risk is not volatility. Possible to speak more about this? Charlie, I love you, but you're wrong. So I will say this about risk and volatility. Risk and volatility are not the same thing, but they're related. I'll give you that. Periods of market volatility do tend to bring out bad behavior in clients. But I think part of that is because we as a profession have coupled those things when they ought to be decoupled.

As we focus on goals-based systems, as we focus on living the life that they want to live, and are they hitting the bogeys that they need to hit in order to live the life that they want to live and not benchmarking to something that's impersonal and external to them, I think that we're going to see greater responsiveness from our clients. So I do agree that periods of market volatility do tend to bring about risky behaviors. But I disagree with the classical economic notion of volatility as a proxy for risk.

If process is more important than discretion, should we all have robo-advisors? I think I touched on that.

Do you think there is a future for active management? I'll end with this one. Is there a future for active management? If yes, what does it look like? I think there is a bright future for active management I think passive managers have become increasingly smug in the last six to seven years, and I think that the smiles are soon to be wiped from their faces because of some of the things that I've talked about today.

I think that the ability of active managers to add real value, though, depends on their ability to do the things that we talked about today. Are they going to deliver high-conviction, rules-based, low-tax, low-turnover models that really give our clients what they need? Or are they going to continue to closet benchmark? I think there's no future for closet benchmarking, and that the wheat and the chaff will be separated in the coming years, both by investors and by regulators. Thank you.


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