Investing is full of potential obstacles. Most investors think that if they could just figure out what happens next, they can easily avoid the future obstacles in their path. But few investors ever realize that the biggest obstacle is themselves.
The Laws of Wealth: Psychology and the Secret to Investing Success shows investors how to get out of their own way. Through studies, stories, and humor, Dr. Daniel Crosby lays out what every investor faces at some point – sometimes often – in their investing life. Their behavior compounds mistakes rather than their money.
The book is broken into two parts. The first part of the book is dedicated to ten rules that help you manage your behavioral risk. You control what matters, trouble is opportunity, excess is never permanent, and risk is not a squiggly line are a few of the rules.
Why is it important to understand these risks? Because anything that works against you can be exploited by other investors. As Dr. Crosby explains, your disadvantage, with the right set of rules, can become an advantage.
The psychology of individuals – warts and all – must be a central consideration in the formulation of any practical investing approach. The good news here is that others’ misbehavior will consistently and systematically create opportunities for you. The bad news is that you are prone to all of the same quirks and are just as likely, in the absence of strict adherence to the rules, to create the same opportunities for others.
The second part of the book is dedicated to turning the risks into a rule-based process you can follow in your investing strategy.
In the book, Crosby breaks down the many behavior biases into five main types. The idea is to combat each type with a simple rule-based process that helps you focus on what matters. In doing so, you can avoid most of the behavioral risks inflicting investors.
Crosby asks readers to act more like the House instead of the gambler. Most people understand the saying, “The House always wins.” Casinos have an edge for a reason. It turns the player’s behavior into the House’s advantage. Well, investors can choose to do the same.
Perhaps you know a friend who gambled big on a single stock and made a great return. Results notwithstanding, your friend is a moron. Maybe you jumped out of the market right before a precipitous drop because of nothing more than a gut feeling. Lucky you, but you’re still a moron. Exceptional investing over a lifetime cannot be predicated on luck. It must be grounded in a systematic approach that is applied in good times and bad and is never abandoned just because what is popular in the moment may not conform to longer-term best practices. Just like a casino, you will stick to your discipline in all weather, realizing that if you tilt probability in your favor ever so slightly, you will be greatly rewarded in the end…casino odds demonstrates, a small edge, consistently exploited, can produce impressive returns. Casinos don’t win by virtue of a huge advantage. They win through good behavior and relentless exploitation of edges.
A number of edges persist in the market because, on the whole, investors consistently behave badly. Crosby cites value and momentum as two edges and gives a few examples of each (he reminds you that successful investing is also about what you avoid like risks around bankruptcy and accounting fraud).
The point is to attack these edges in a rule-based way.
Rules help you automate decisions that would normally run afoul of behavioral risks. Rules help you focus on process over outcome. The process, in this case, is in exploiting the edges. The edges might not show immediate or consistent results but will produce a favorable outcome over time. And that’s why the House wins.
Armed with this new information, how do you take the ideas and put into practice? What tools exist that help you take advantage of the edges (value and momentum) discussed in the book?
The book is a great introduction to behavioral risk and fully explains why rules work. So the book is worth reading just for that. In fact, it basically explains why I switched to a rule-based strategy several years ago.
The hard part is putting these ideas into practice. From my own experience, frictions exist – cost, education, lack of tools, and time, to name a few big ones – that make it difficult to exploit the edges easily. In short, most people won’t do the initial work (if it were easy, everyone would do it). Those that do have a huge advantage over everyone else.
All that aside, The Laws of Wealth is great at explaining the self-imposed headwinds investors face and why rule-based investing helps overcome it.