Counsel Views – Episode 6: Michael Sherman

Stu Morrow (Host):

Hello, everyone. Thank you for joining us today.

Throughout my career in the investment industry, I've spent a lot of time trying to better understand anomalies and events that take place in global financial markets. For instance, why does the market at times seem to go up and down irrespective of what's happening in the economy? Why do bubbles seem to persist throughout time in financial markets, and what makes it so difficult for investors to avoid the dreaded buy high and sell low trap during different market environments? Famous investor Warren Buffett once said, "It won't be the economy that will do in investors, it will be investors themselves."

My guest today to help answer some of these and other questions is Michael Sherman, Head of RBC's Behavioral Economics Team. Michael and his team provide insights into the practical application of behavioral economics on a customer experience at RBC. He's a member of Yale University's Behavioral Economics Think Tank, and is the founder of Canada's Behavioral Economics Industry Association.

He is a graduate of the University of Toronto’s Faculty of Law and a member of the Law Society of Ontario with an MBA from the Ivey School of Business. Michael has appeared as a guest on several TV shows and has published articles in several major newspapers, including the Globe and Mail. Hi, Michael, welcome to Counsel Views. Happy to have you with us today.

Michael Sherman:

Hi, Stuart. Thank you so much for having me on the podcast.

Stu Morrow (Host):

Great. No, good to have you. Michael, maybe we could start off having you explain to our listeners what you do at RBC?

Michael Sherman:

Yeah, absolutely. I'm very pleased to be the Head of Behavioral Economics for RBC, and our job is to help people in our organization understand how clients think, feel, and act. I guess a good way to start off is to say that traditional economics is an excellent way to determine how people should act, what decisions they should make.

But a lot of people make decisions based on their emotions, on rules of thumb, on their intuition, and in some cases, those decisions could lead people astray. In other words, they don't align with their goals. Our job is really to help the bank help other people achieve their goals and not get carried away by cognitive biases that can tend to affect the way they make decisions.

Stu Morrow (Host):

The emotion, the rules of thumb definitely hit home. Thinking about our listeners, investors, the study of behavioral biases in behavioral economics. Can you explain to our listeners how maybe developing a better understanding of some of these biases could help them as investors, and even as advisors as well?

Michael Sherman:

Well, I love the way you started off the podcast because a lot of the questions you posed were the questions that got me interested in behavioral economics. You've probably seen this type of behavior time and time again, that people get caught up with markets and follow the bandwagon. When the markets are high, they want to invest more and more without paying attention and analyzing the fundamentals.

In some cases, when the market's low people might panic and not act in a way that fits with their general plans. I was always amazed at why people had these biases? Why they somehow found that their emotions were not working in their best interest? I guess it's good to take a step back and say that in many cases people should and do rely upon their emotions and intuitions, and it's a great time saver.

I mean, think of the processing power that our brains have to set out every day when we try to make decisions. I mean, we'd literally be stopped flat in our tracks if every decision we made, we had to analyze carefully, thoughtfully using what's called slow thinking.

But our brains are able to take shortcuts. Instead of walking into a Starbucks and assessing every single choice that you could make for a beverage and a food, we just order the same thing time and time again, or maybe it's a medium coffee. That way we save our brains from working too hard.

In a lot of cases, these shortcuts benefit us. We've evolved to have these shortcuts to make our day go smoother, to not stop us in our tracks. But in some cases, particularly with financial services, these biases can work against our interests. If we could identify when these biases kick in and lead us astray, if it's predictable, which it certainly is, then hopefully we can prepare and put into place guard rails, or ways to nudge ourselves or have other people nudge us to make decisions that align with our goals.

Stu Morrow (Host):

Very good. I think we'll get to a few of those nudges in a second. I wonder if it's maybe worth some time just talking about a few of these biases that you think are more prevalent, maybe amongst investors? Or ones that you come across in your work with RBC that you may think people might be interested in? Or it's a good place to start that conversation around behavioral economics and behavioral investing.

Michael Sherman:

Sure. Are there any particular you'd like to focus on or should I just suggest some of the ones that I find fascinating?

Stu Morrow (Host):

Yeah, I mean you touched on the idea of a bit of regret, maybe some overconfidence in optimism in there as well. I'd like to hear about that. If there's another bias that keeps coming up, that'd be interesting to hear as well.

Michael Sherman:

Well, yeah, loss aversion is a key to investing and that really starts with two behavioral scientists, Daniel Kahneman and Amos Tversky, who really did some experiments 30 years ago to determine how people reacted to losses. They came up with a theory called prospect theory, and one of the fundamental principles behind that is the idea that people dislike losses, or the intensity of losses is twice as severe as the pleasure people get from equivalent wins.

To put that another way, if somebody loses $20, they had it in their wallet and it disappeared, they will be twice as upset as they would be happy if they found a $20 bill. This has some enormous impacts because people tend to want to avoid losses. This could impact them by, for instance, if they have a portfolio of stocks and for some cash-flow reasons they have to sell one, they'll tend to want to sell their winners. Because if they sell one stock that has gone down since the price that they purchased it, they're admitting that they're losing, they're losers. When actual fact, there are a whole bunch of other considerations that are important in deciding which stock to sell.

But the way that people behave differently when they face losses has an enormous impact on the way that people invest. When, for instance, if somebody owns a stock, it immediately shoots up in value, and then over time it starts to decrease and it gets close to the point that they purchased it at, some people find that an intense feeling. They don't want to admit that they lost, so they'll pay more attention to that stock. They'll be very aware of the fact that it's gone under the price that they paid for it, and they're anchored on to the price that they originally paid for it.

What I'm saying is that the fear of losses can have an enormous impact and can even force people to be more risky and take bigger bets to avoid a loss. It's good to know if you have loss aversion or it's a factor in your investment decisions.

Stu Morrow (Host):

That's great. I tend to go back to where we were in maybe the early part of 2020 and severe market volatility as a result of Coronavirus spreading and the economy shutting down. Maybe there was a lot of people who maybe have exited the market in some fashion, and find it very difficult to get back in despite the rebound the markets have seen, and arguably some of the economic data points that have improved as well.

What are some of those... what's some of those behavioral biases behind that decision to sort of say you sold, you can't get back in, things are still dire out there, and the data's not as good. There has to be a lot going on behind that. Is there anything that you can point to, and then look at that and say, "Yeah, there's definitely a few biases involved in that sort of behavior."

Michael Sherman:

Yes. One of my favorite quotes in behavioral science is by an author from the Wall Street Journal, Jason Zweig, who once said that there's a big difference in asking somebody if they're afraid of snakes than their reaction might be if you throw a snake on their lap and then ask them, even if they want to answer.

A lot of people if they're asked can they withstand a decline in the value of equities might say, "Yep, of course. I could easily withstand a 20 or 30% decline." But they don't experience the intense emotions that they feel when they see the steep declines happen day after day, when they read the news, when they turn on the TV and see the sharp arrows pointing downwards.

A lot of people when they're faced with market declines for the first time, which of course are a normal part of the market cycle, and it's not to be unexpected that there will be contraction. But when these people see for the first time how it feels, what the emotions are like to experience steep market declines, some of these people might find that they are no longer tethered to their plan, that they want to get to the sideline, that they might panic. When they do, they get into fight flight or freeze mode.

It's very important for you to know how you're going to react when you're faced with the emotion of a steep decline. If you are particularly investing your nest egg, I don't think anybody wants to find out that they can't take it or at least find it too emotionally stressing for them.

It is quite important to know that it is very different to simply conceptualize, yes, I can take a loss. But once you are actually at the point where you have to experience it, new emotions fill you, and in some cases, chemicals, neuro chemicals change the way that you make decisions. You're not the same person when things are calm and the market goes straight up as when the market drops. This is just one element of loss aversion.

Stu Morrow (Host):

Good point about the other side of that, which would be when the market is, like you said, sort of calm and rising, probably speaks to a little bit about risk taking and risk seeking behavior. Maybe that's a good next question for you is, when you think about personalities, how do they influence risk seeking or risk avoiding behaviors? Past experiences, upbringing, culture, the environment, does that all factor in from a behavior perspective when you talk about risk, especially on the investment side?

Michael Sherman:

Yes. I think people's personalities can have an enormous impact on their investing behavior. I also enjoyed the way you started the podcast, quoting Warren Buffett. His partner, Charlie Munger, also shares the view that emotions can hijack your investment decisions, that people are far better off not letting their emotions guide them on what decision they make. It's better to make investment decisions in a cool state of mind.

I think it's important for people whose personalities are less neurotic, who are more analytic. Those people usually are quite able to handle market turbulence, but there's another side of the coin. Those people who are more emotional or who are worriers, who find that they fall into some behaviors that cause them to increase their emotion over time.

One, would be excess checking of stocks. Studies have shown that people are far happier if they don't check their stocks on a daily basis, if they don't check the value of their portfolio week by week. They're going to be much happier if they do it once a quarter, once a year. But then some people fall into the trap.

We all have cell phones, with many of us have stock apps where we can see the price of stocks on a momentary basis. If you find yourself looking at the price of stocks too often, or the values of indices, that can trigger certain emotions at all times. People might see, for instance, losses and they're going to react very negatively because as we know, losses are twice as intense as gains. It's much better for people who have personalities who can take it.

Like I said, if you are emotional, it's good to know it beforehand. There are ways to determine whether or not you need guidance. Perhaps I could just add as well, that's one of the benefits of having an advisor who can be a behavioral coach. Somebody who can walk you through the norms. Somebody who won't let you get caught off guard.

An analogy I like to give is it's like many of us might be sitting in a boat watching a licensed driver and just steering the boat easily, and we think, "Hey, we can do that." Probably there's nothing that appears too difficult about that. But behind the scenes, this is a trained pilot of a boat. This person would know how to handle any sudden catastrophe, whether it be bad weather, bad waves. I don't think you want to just assume and be overconfident that you could handle it on your own. A trained coach can be an enormous benefit to people when their emotions kick in.

Stu Morrow (Host):

I wholeheartedly agree, not just given the position I am with Investment Counsel, but I do know several academic studies that go back and look at the difference in terms of the experience of mutual fund holders to the mutual funds themselves over 20, 30, 40 long periods of time, and the experience differential can come down to behavior. Behavior that could be maybe, as you were saying, nudged in the right direction with a counselor, with an advisor who is properly trained. Totally agree there.

Speaking of that, I mean even thinking about investment process. One of the things you've mentioned is talk about slowing things down, not reacting to the noise, not reacting very quickly. Following that rules-based approach that goals-based investing is something that we're very big proponents of at RBC PH&N Investment Counsel. Is there anything else that you think investors can be doing to minimize the impact of some of the biases we all have to some degree?

Michael Sherman:

One of the biases I've been studying recently is overconfidence, which is tied into optimism. Naturally, humans are confident people, but it's remarkable how overconfident we tend to be. If you ask a group of a hundred people, how many people think are above average drivers? Studies have shown perhaps 90% of people would think they're above average, and by definition, only 50 can be in that group. In almost every case, if I were to ask people, at work particular, are you above average in terms of your abilities? Nobody likes to admit that they're not.

There are two behavioral scientists, David Dunning, and Justin Kruger, who came up with an effect. They wrote a wonderful piece saying that people who lack the skills and experience to know whether or not they're adept or are able tend to be overconfident. Because by definition, they don't know what it takes to be really competent.

They wrote a fascinating paper. They started it off with a great story about a fellow in Pittsburgh who robbed a bank. He decided, he read somewhere that if you put lemon juice on your exposed skin, you'll be invisible. He covered himself in lemon juice and was just confident with the fact that people could not see him, he'd be invisible. The guy actually robbed one bank and was filmed on the camera, then tried to rob another bank. When they stopped him, his response was, "Well, I'm wearing the juice." Ironically, this guy was not mentally ill. He just was overconfident. He didn't know what it took.

On the other side of the coin, people who are exceptionally able, they tend to underestimate their confidence because they know how difficult it was to get to the point of being an expert, and they still think there's so much to learn. When we perceive people who appear exceptionally confident, we must think... Many people tend to think that this person knows what they're talking about. It's just a flaw in the way that humans communicate. But not everyone who is confident is competent.

Stu Morrow (Host):

Good point. Although I do, I am probably one of the world's greatest drivers, but that's beside the point. As we end off each one of these Counsel Views, Michael, we ask guests are there any podcasts, books that you would recommend to our listeners if they were interested to further their own study and understanding on the behavioral economics side?

Michael Sherman:

Well, I could go on and on about my favorite behavioral science books. The one I'm reading right now is fascinating. It's by Olivier Sibony, and he's a French behavioral scientist. He wrote a fascinating book called You're About to Make a Terrible Mistake. He does a wonderful job of going through bias by bias.

I also finished rereading a couple books. The Behavioral Investor by Daniel Crosby, who talks about the benefit of having a behavioral coach and automating your decisions. I'd recommend them both. Of course, BJ Fogg's book on habits, Tiny Habits, is an exceptional book. That is a book that helps people form better habits and get rid of habits that aren't to their benefit.

Stu Morrow (Host):

That's great. Michael, thank you on behalf of RBC PH&N Investment Counsel for taking the time to speak with me today, sharing your thoughts on these key topics. We'd like to have you back again at some point in the future to have a further discussion. But I do wish you well and take care and hopefully speak to you again soon.

Michael Sherman:

Thank you, Stuart. A pleasure.

Stu Morrow (Host):

Thank you, Michael.