Standard Deviations with Dr. Daniel Crosby

Our brains are designed to privilege safety and certainty over happiness and growth. Understanding this simple truth, we begin to realize that the time will never be perfect to do the thing we've always dreamed of and learn to press forward in spite of our fears.

How to Avoid Financial Scams

Stephen Greenspan is a psychologist and author of the Annals of Gullibility: Why We Get Duped and How to Avoid It. Greenspan’s book outlines notable instances of gullibility including the Trojan Horse, the failure to locate weapons of mass destruction in Iraq and the bad science surrounding cold fusion. Most of the book focuses on anecdotes, but the final chapter sets forth the anatomy of being fooled and attributes it to some combination of the following factors:

• Social pressures – Fraud is often committed within “affinity groups” such as people who hail from a similar religious background.

• Cognition – At some level, being duped represents a lack of knowledge or clarity of thought (but not necessarily a lack of intelligence).

• Personality – A propensity toward belief and difficulty saying “no” may lead people to be taken advantage of.

• Emotion – The prospect of some emotional payday (e.g., the thrill of making easy money) often catalyzes questionable decision-making.
In a field that is sorely understudied, Stephen Greenspan literally wrote the book on the topic. He is not just an expert on gullibility, he is the expert on gullibility. Which is why it may surprise you that he also lost 30% of his wealth to notorious fraudster Bernie Madoff.

In a candid assessment of his own gullibility, Greenspan wrote in the Wall Street Journal:

“In my own case, the decision to invest in the Rye fund reflected both my profound ignorance of finance, and my somewhat lazy unwillingness to remedy that ignorance. To get around my lack of financial knowledge and my lazy cognitive style around finance, I had come up with the heuristic (or mental shorthand) of identifying more financially knowledgeable advisers and trusting in their judgment and recommendations.

This heuristic had worked for me in the past and I had no reason to doubt that it would work for me in this case.
The real mystery in the Madoff story is not how naive individual investors such as myself would think the investment safe, but how the risks and warning signs could have been ignored by so many financially knowledgeable people, including the highly compensated executives who ran the various feeder funds that kept the Madoff ship afloat. The partial answer is that Madoff's investment algorithm (along with other aspects of his organization) was a closely guarded secret that was difficult to penetrate, and it's also likely (as in all cases of gullibility) that strong affective and self-deception processes were at work. In other words, they had too good a thing going to entertain the idea that it might all be about to crumble.”

Greenspan has excellent insight into his own decision-making and motivation. He admits that he was relying on a shortcut (“Let other people think about it”) that had worked in the past, without considering why it might not work this time around. Likewise, the professionals in the story had no interest in critically examining a system that was making them look like geniuses! As Francis Bacon said beautifully, “The human understanding when it once adopted an opinion draws all things else to support and agree with it. And though there be a great number and weight of instances to be found on the other side, yet these it either neglects and despises or else by some distinction sets aside and rejects; in order that by this great and pernicious predetermination the authority of its former conclusions may remain inviolate.”

Just as Irvin Yalom found it difficult to entreat young lovers to think critically about the potential flaws in their relationship, it is nearly impossible to get someone who is making money to ask, “Why might I be wrong?”

Let me ask you a question, “Do you like laugh tracks?” Didn’t think so.

If laugh tracks are so universally disliked, why do Hollywood executives continue to include them? These executives understand something that we may not; however irksome canned laughter may be, it provides valuable social cues to viewers. Research has repeatedly shown that laugh tracks cause viewers to laugh longer and harder and to rate the viewing experience as more enjoyable. In fact, laugh tracks have been shown to be most effective at improving the appraisals of jokes that are especially bad! We are programmed to do what others are doing, even when those others only exist on tape.
Social mimicry is ubiquitous. Panhandlers often salt their tip jars with money from the day before to show that giving is proper behavior and that other people have deemed them worthy of a handout. A beggar with no money in his cup is perhaps more deserving of a dollar, but also far less likely to get that dollar than the beggar who already has three.
One of the most cost effective ways to extinguish a fear in children is to have them observe other children performing the anxiety-inducing behavior. In one study, 67% of children with a fear of dogs were “cured” of this phobia within a week, simply by watching other children pet Fido. Even something as serious as suicide is subject to the effects of social mimicry. Dr. David Phillips of the University of California at San Diego found that “within two months after every front-page suicide story, an average of fifty-eight more people than usual killed themselves.” In laughing and crying, living and dying, it would seem that the behavior of those around is far more contagious than we may have ever supposed.
Mirror neurons and other mechanisms of the brain facilitate the precious gift of empathy, an invaluable resource when building relationships and community. Though we may not have experienced exactly the same joys and sorrows, we can vicariously experience each other’s emotions in a way that allows for comfort, support and even shared elation.
But, in what is becoming an ever-stronger theme here, the very mechanisms by which we form community and share each others’ burdens make us poor investors and more concerned with keeping up with others than providing for our own needs. As Jason Zweig says, “...investing isn’t about beating others at their game. It’s about controlling yourself at your own game.”

Momentum has existed for hundreds of years and has persisted for two decades post discovery. This sort of staying power in capital markets full of hungry arbitrageurs is always the mark of human psychology.

Many experts consider momentum to not just be a factor but THE factor. Fama and French don’t mince words, “The premier market anomaly is momentum. Stocks with low returns over the past year tend to have low returns for the next few months, and stocks with high past returns tend to have high future returns.” As James O’Shaughnessy says, “of all the beliefs on Wall Street, price momentum makes efficient market theorists howl the loudest.” In a perfect world, there would be no good reason to pay more for a business today than yesterday simply because of positive price action. But this isn’t a perfect world, it’s a world ruled by human behaviour and thus exhibits all of the attendant quirks.

Like peanut butter and chocolate, momentum and value are wonderful on their own, but even better together. Cliff Asness says it best in his piece, A New Core Equity Paradigm:

“Value and momentum remain the two strongest findings of academic and practitioner research of the last 30 years. While academics continually identify new market anomalies, which purport to offer significant risk-adjusted excess returns, and the Street routinely spins new stories to sell them, value and momentum stand head-and-shoulders above the rest-no other styles have performed so well, for so long, and in so many places. Both value and momentum have long histories of providing attractive returns, have performed well across markets and across asset classes, and have persisted for decades after their discoveries. Importantly, the two strategies perform even better when combined.” Value and quality work, independently and in concert, precisely because they exhibit the three hallmarks of an investable factor: empirically evidence, theoretical soundness and a behavioral foundation.

We commonly speak of how "stressed out" we are today but as recently as a century ago, the idea of stress was viewed as unscientific. In this episode, we talk about the physical psychological impact of stress on investment decision-making and risk appetites. The takeaway? Good investing is so difficult partially because it is physically painful.