Behavioral Finance and How to Avoid Making Poor Investing Decisions

In a recent episode of the Validea podcast Excess Returns, Justin Carbonneau and Jack Forehand had an in-depth discussion about the coronavirus pandemic with Daniel Crosby, Ph.D., chief behavioral officer for Brinker Capital. Specifically, Dr. Crosby shared valuable insights and tips regarding human psychology, behavioral finance, the market and how investors can avoid making poor decisions during this time of uncertainty.

Here are some highlights from the interview:

  • Crosby referenced the 5-factor model for wellness developed by Martin Seligman, Ph.D. called the “PERMA” model (an acronym for positive, engagement, relationship, meaning and advancement). Touching all five “bases” each day or week with intention—incorporating positive experiences, social engagement, focus on relationships, effort toward something “bigger than yourself,” and moving yourself forward in some way–Crosby says, can help people navigate this period of uncertainty.
  • The re-opening of the economy, Crosby predicts, will “deepen some class distinctions and economic disparities in our country,” adding that those who can afford to stay home longer will do so but that many do not have such flexibility. The forces of protecting the economy and protecting human life are at odds, says Crosby.
  • There are pros and cons to the increased use of technology, according to Crosby. He underscores the benefits of making interactions as much like “real life” as possible: Video is better than phone, but phone is better than text, he says. And while there is no substitution for face-to-face interaction, Crosby argues that the pre-pandemic environment that was rife with frequent, large conferences and heavy business travel encouraged a lot of waste. Going forward, he said, “I hope we land somewhere in the middle.”
  • Regarding how investors can keep their behavior in check during these times, Crosby outlined a “three-P’s” process as follows:
    • Purpose—revisit and remind yourself of your long-term investment plan.
    • Proof—refer to market history to gain context and perspective about what has happened in prior downturns and pandemics.
    • Process— “Keep your hands busy doing something positive.”
  • Risk tolerance is only one aspect of investor behavior, says Crosby, who contends that the industry must “do a better job learning how to measure risk composure” which dictates how investors behave when they are flooded with anxiety. “Education is a weak predictor of behavior,” he says, noting that decisions made in the heat of the moment can often fly in the face of what we know is the more prudent course of action.
  • To avoid making mistakes, he says, investors should lean on rules-based, systematic approaches to investing decisions to avoid letting opinions and emotions derail investing objectives. Investors should also “have someone to slap the bad decision out of your hand” like a financial advisor.
  • While the current situation will certainly leave scars on people, Crosby asserts that we have also seen “some of the best of human nature” during the pandemic and underscores the power of optimism.  He cites his belief (not prediction) that we will face a “tough couple of years, then an unprecedented period of economic prosperity.”