Think Like a Freak, written by the Freakonomics podcast team, says a lot about behavioral finance – that is, the real (versus rational) ways people manage their financial lives. Much of it can be applied to investing.
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Life with Money
I’m a relative latecomer to podcasts. I had heard a lot about them, of course, but hadn’t really tried them out until the last year or so. (I’m a notorious late-adopter of pretty much all new media and technology.)
We started with Serial, and then moved on to Office Ladies, featuring Jenna Fisher and Angela Kinsey dissecting each episode of our favorite TV series, The Office. Podcasts turn out to be a great way to spend an hour (or more if bingeing), especially on a long car ride with nothing much else to do.
More recently, I’ve started to listen to the Freakonomics podcast. Hosted by Stephen Dubner, an author and journalist, Freakonomics bills itself as exploring “the hidden side of everything.”
While this seems a little excessive, I’ve found many of their episodes very informative and entertaining. Recent favorites include ones about whether middle managers matter (they do, but only for staff retention purposes), and a three-part series on Adam Smith and his legacy (much more complicated than just the ”invisible hand”).
Dubner’s Freakonomics partner is Steven Levitt, an economics professor at the University of Chicago. Levitt hosts his own podcast, People I (Mostly) Admire, which I’ve been listening to as well. Excellent recent episodes featured interviews with Peter Singer, a professor of Bioethics at Princeton, and Yuval Noah Harari, author of Sapiens and Homo Deus, among other sweeping works of history and philosophy.
Think Like a Freak
With this introduction to Dubner and Levitt’s work, I eagerly started their 2014 book, Think Like a Freak, which “offers to retrain your brain.” (Again, a little much, but they do seem to have fun with their subtitles.)
I thought they might have some interesting things to say about behavioral finance, which studies the real ways people manage their financial lives, as opposed to the “rational person” fiction used in classic economics. It turns out they do, and much of it complements the advice PPA has provided clients for many years.
I think it’s useful first to present the broad guidelines of their thinking. They use what they call the “economic approach” (page 9). This isn’t necessarily just about economics, but instead “relies on data, rather than hunch or ideology, to understand how the world works, to learn how incentives succeed (or fail), how resources get allocated, and what sort of obstacles prevent people from getting those resources.”
In addition to the importance of understanding incentives, they focus on figuring out what to measure, and how to measure it; challenging conventional wisdom; and emphasizing that correlation (i.e., two or more things occurring together) does not equal causation (i.e., one or more of those things causing one of the others).
The book is full of other useful techniques and fascinating examples, including:
- Think small (page 89), with a section on improving education by providing inexpensive glasses to low-income kids
- Don’t fear the obvious (pages 78-83 and 101), with a discussion about the scientist who figured out the cause of ulcers
- Strategic thinking (pages 140-2), with a story about the ingenuity of Van Halen frontman David Lee Roth
- Sunk and opportunity costs (page 191), with arguments for the benefits of quitting in certain situations
- Pre-mortems (page 199), which advocates for thinking seriously about what could go wrong before starting a new initiative, as a response to the Challenger space shuttle disaster in 1986
Dubner and Levitt don’t take up investing in any detail in this book, but they do have suggestions that we think can help in your life with money.
Try to Understand and Avoid Biases
Dubner and Levitt say (page 10) that it’s “difficult to think like a freak … It’s easy to let your biases – political, intellectual, or otherwise – color your view of the world. A growing body of research suggests that even the smartest people tend to seek out evidence that confirms what they already think, rather than new information that would give them a more robust view of reality.”
“It’s also tempting to run with a herd. Even on the most important issues of the day, we often adopt the views of our friends, families, and colleagues … But running with the herd means we are quick to embrace the status quo, slow to change our minds.” (We’ve written about the financial perils of herding in relation to cryptocurrency.)
In personal finance, these biases are often expressed as assumptions that markets will continue to perform as they have most recently, either up or down. Park Piedmont encourages clients instead to “re-balance” your portfolios over time.
This involves buying more of the category that has performed worse and/or selling the category that has performed better, in order to return your portfolio to the asset allocation we worked together to determine appropriate for your situation. This also means buying low and selling high, which typically provides much better long-term returns than simply following the markets’ current direction.
Admit What You Don’t Know
As Dubner and Levitt put it (page 20), “It has long been said that the three hardest words to say in the English language are I love you. We heartily disagree! For most people, it is much harder to say I don’t know. That’s a shame, for until you admit what you don’t yet know, it’s virtually impossible to learn what you need to.”
Admitting the limits of our knowledge, which we refer to as humility in developing investment strategies for clients, plays a key role in PPA’s investment approach. We favor indexed investing because it acknowledges how difficult it is to outperform the public markets for stocks and bonds.
The alternative approach – trying to pick winners and/or losers (i.e., short selling), and charging clients much more for the privilege – has been shown in countless studies to be difficult if not impossible, even for short periods of time. Better to own inexpensive funds in a diversified portfolio designed to accomplish your long-term goals.
Folly of Prediction
This is one of our favorite lessons, and Dubner and Levitt get right to the heart of the matter (pages 22-25):
“What we ‘know’ can plainly be sculpted by political or religious views. The world is also thick with ‘entrepreneurs of error,’ as the economist Edward Glaeser calls them, political and religious and business leaders who supply beliefs when it will increase their financial or political returns.”
“It can be hard to ever really ‘know’ what caused or solved a given problem – and that’s for events that have already happened. Just think how much harder it is to predict what will happen in the future.”
“Research shows that … prominent pundits … tend to be ‘massively overconfident’ even when their predictions prove stone-cold wrong.”
We see so many examples of this folly that it would be laughable, if only people didn’t sometimes take it seriously and act on it. Just this morning, I read a headline saying that JPMorgan calls a “recession inevitable by the end of the year” (InvestmentNews, 4/3/23).
A recession might or might not happen, and it’s important to try to understand the many factors that influence the eventual outcome. But there’s certainly no basis for saying anything in the financial area is inevitable.
We consider this irresponsible, and think it is likely designed to scare clients into actions that might generate short-term benefits for the firm rather than long-term benefits for the client. PPA avoids predictions in all cases, focusing instead on developing appropriate long-term allocations for clients that don’t rely on guessing which way the markets will go.
We’d love to hear if any of these ideas resonate for you and will continue to highlight what we consider interesting takes on the economy and personal finance.
We’d love to meet you – by phone or video if you prefer, or in-person.
Contact 20-year Piedmont resident Nick Levinson to learn more: nickl@parkpiedmont.com.
Founded in 2003 as an alternative to the Wall Street advisory model, Park Piedmont Advisors (PPA) is an independent, multigenerational family-owned firm, dedicated to client-centered relationships. Decades of experience inform our straightforward approach to investment and financial advising; we help our clients protect, build, and share their wealth in a low-cost, tax-efficient manner.
As a fiduciary, we provide thoughtful advice to individuals, families, and the retirement plans of small businesses and non-profit organizations (including 401(k), 403(b), and defined benefit plans). And through our advisory process, we help clients gain insight into the ways financial decision-making can express and transmit their core values.