Andy Cross (3:24)

You know, it's funny because you quote Charlie Munger at the very beginning. Don't try to be smarter than anyone else. Just be less stupid. And I feel like I'm kind of like eating my spinach before I get to my dessert. Like you're giving me these kinds of like, oh, my gosh, these great lessons I've observed, you've observed over your years and years of investing wisdom to start with those mistakes. And you make the parallel with tennis. You know, it's about making those unforced errors we have to be very, very cautious about in investing.

Barry Ritholtz (3:50)

That's right. Tennis is a good metaphor. Driving a car on a racetrack is a good metaphor. And investing, basically, the problems happen when we try and operate out of our skill set and expertise. So the example the other Charlie gave Charlie Ellis in winning the losers game was it's really two games in one. The games the professional play and the game that the amateurs play. You know, we're recording this. Djokovic is on pace to possibly winning yet another Grand Slam event. And folks like him win by scoring points. They have incredibly powerful serves, they hit with great precision. They use all sorts of fancy spins, they kiss the line. That's not how I play. And when I lose, it's because I double fault on a serve. I hit it long, I hit it wide, I hit it into the net, or I hit it right back to the sweet spot of my opponent. All those mistakes lead to unforced errors and points for the other side. If you want to win when you're playing the amateur game, not the professional game, just make less mistakes. Just don't try and overpower the ball. Don't try and be too fancy. Keep it away from your opponent. But don't think you're going to just kiss the line, you don't have those skills. And so we see when people operate outside of their own ability, that's where they make mistakes that cost them money. And in the markets that means, hey, I'm gonna create an all personally picked stock portfolio. I'm gonna time the market, I'm gonna follow this news flow and bet on my understanding of what's going on and what it means for the markets. When the reality is that news is already in the price, there's no advantage to taking public information and thinking that you're going to be able to trade against the professionals, trade against the guys with 150 mile an hour serves.

Jason Moser (5:47)

Barry, forgive me, I probably would have gone with golf as the metaphor, but that's just me. But the lesson rings true. I mean, you just avoid the silly mistakes, the unforced errors. I really enjoyed the book. It seemed like a predominant theme in the book leaned a lot more towards passive investing versus active. And to be sure you presented data to back that up. But I guess I wanted to ask, what's your general view on active investing and what would you say are the keys for active investors to outperform?

Barry Ritholtz (6:15)

Sure. So the first step for assembling a broad portfolio is, hey, you can't get alpha if you aren't at least starting with beta. And you'd be surprised how many people just neglect that. So I love the idea of making the core of a portfolio. I describe it as your Christmas tree should be your passive portfolio and your active selections are the garland, the lights, the ornaments all around that. But if you at least start with beta, hey, you're at least going to get what the market takes. We've learned on that active does much better on the bond side than passive does. So you have to be really selective where you're applying passive investing. You have to have a degree of awareness. Stock picking is so hard. In fact, the data shows professional managers are really good stock pickers. They're really bad stock sellers or stockholders. So look at the biggest companies out there, the leaders in the market, Microsoft, Nvidia, Apple, Amazon, go down the whole list. They've all had incredible drawdowns on their way to becoming trillion dollar companies. I mean, when AI came out, we heard that this is the end for Google and a lot of people lightened up on Google. It took a big hit and now Google is double what it was when I think Anthropic first launched in 2022. So it's so much more challenging to just because something rolls over and draws down doesn't mean it's the next Enron, WorldCom, Lehman, Bear, Stearns, whatever. And so recognizing that it's really a challenge, look at the drawdowns you saw following the dot com implosion in Microsoft, Apple. Amazon was a $5 stock in the early 2000s. It's sort of unthinkable. And Apple, when the ipod rolled out, was a $15 stock with 13 cash and nobody wanted to touch it. So you really have to be very aware of what your ability is. Hey, if you want to pick stocks, well, knock yourself out. Just do so with a smaller portion of your portfolio and make sure you actually have some skill at it. Not just finding the winning stocks, but understanding how to hold them and when to finally cut them loose.

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Jason Moser (9:54)

To mistakes because that, you know, is really what the book is all about, how not to invest. And you had a nice section of the book on investing mistakes. And given this is a conversation about how not to invest, what would you say are a few of the more common mistakes you see investors make today?

Barry Ritholtz (10:10)

So it depends on where people are in their investment cycle, how old or young they are. And I'm going to give you a lot of stuff that comes straight from the data. What we've seen in the 2010s that started to change in the 2000s, young people were taking too little risk. They were underinvested. Hey, if you're 25, 30, even 40 years old and you have a time horizon that's measured in decades, not years. If you're 25, you have a 40, 50 year time horizon. Why would you be sitting on a pile of cash and or bonds? You should be pretty much if not all equity because some people that's a little too aggressive, mostly equity for the long haul. And a combination of a broad index and pick your favorite stocks for the next 20, 30, 40 years works better than. So that's one issue. We see people wildly underinvested when they should be embracing risk. The other end of the scale we see people in their 50s and 60s, heavily concentrated portfolio, lots of wealth in a single stock. It could have been an employer, it could have been inherited stock. Hey, why are you taking all this risk? You're already sitting on a giant pile of money, enough to last you the rest of your life. Throttle back. So those are two of the bigger allocation mistakes we see. The other mistake that leads to more mistakes is simply not having a plan like more money for the sake of more money doesn't really do anything. It's got to be what do you want this money for? Once you figure out your goal, hey, then you could figure out the appropriate risk tolerance to get to that goal over time. When we see hedge funds that just lever up 10, 20, 50x leverage in pursuit of more, they invariably blow up. If your goal is more, then how much risk is too much risk? That doesn't guide you. But on the other hand, if you say, hey, I'm saving for retirement, generational wealth transfer, philanthropy, you could create a plan and then marry that plan to an allocation that accepts as much risk as you're comfortable in order to achieve your goals. Now the challenge is risk and reward are two sides of the same coin. If you want higher reward, well then you're going to have to take more risk. And risk means you may not get what you want. And so you know, I love the definition of risk is risk means more things can happen than will happen. And some of those things that can happen aren't good. So how much more risk do you want to assume? We feel you want as much risk as necessary to get to where you have to go, but not a whole lot more than that.

Andy Cross (12:55)

Barry, you mentioned the fascinating fact that it's not so much the buying, it's the selling where investors fall down. And just a quick study that you've referenced in your book looked at what they call the counterfactual portfolio of random cells of more than 780 institutional portfolios and the random cells outperformed the portfolio of active cells by 50 to 100 basis points over the following year. And so my question to you is, why do you think that it's the selling part that investors tend to get so wrong? Because you juxtapose that against the study from Henrik Bessembinder that shows that, you know, 1% or so of the stocks in any given long range period drive almost all of the returns in the stock market.

Barry Ritholtz (13:40)

Right. The Bessembinder study found, depends on the country. One and a half to two and a half depends on what part of the world you're looking at. But the good buyers, bad sellers. I think my explanation makes a lot of sense. The buying process is quantitative and rational. You look at the world, hey, what stocks are reasonably priced? What momentum is going up? Who has a moat? Who has a good product? Like, there are a lot of different schools of thought you can sift through to try and identify those tiny percentage of stocks that do well. And historically, managers have been pretty good at that. And I keep coming back to it's rational, it's logical, it's quantitative. The selling part becomes really squishy. Right? So first, every manager has a finite amount of money. Nobody has an infinite amount of money. So very often when something else comes along, well, we got to sell something to get the capital to buy something. And so you're selling early. You're not giving that stock that you put all this time and effort into researching enough time to develop in the fullness of its revenue and earnings growth. So that's number one. Number two, we see a lot of fund managers when there's a little bit of a squiggle, when there's a little bit of a issue, when a stock falls somewhat, they either panic and sell, or as we've also seen, when it's not just a modest pullback, when there's a fundamental change in the business model, when there's competition, when something happens that should make you go back to your original thesis and say, hey, the reasons I bought this are no longer in effect. We see other managers writing these stocks down to, down to, you know, single digits from giant gains. And all of these seem to be decisions that are emotionally driven. So you have the hard mathematical buys and you have the soft, emotional, squishy sells. And that's why knowing how long to hold something and when to sell it, I feel like it's a lot more art than science, whereas the selection process seems a little bit of art, but a lot of science as well. And so selling is just much, much harder.

Andy Cross (16:01)

It's interesting. Sorry, Jason, just quick follow up is that the behavioral side to the decisions on the selling side is arguably more important than on the buying side.

Barry Ritholtz (16:11)

That's right, because you can take a winning trade and give up the big wins. I described my terrible trade in Apple, which was a triple worst trade I ever made. On the other hand, if you allow either your emotions or your just failure to understand why you own something to get in the way. And look, the reality is all of us investors are humans and we're filled with flaws. We weren't built for this. We adapted and evolved to survive in a hostile world. Deciding how long to hold the stock was not part of our evolutionary history. And so when your fight or flight response kicks in, you know, someone just asked me, I don't understand investors underperform from like 2010 to 2020 a little bit, but they wildly underperformed in the 2000s. Why is that? And my takeaway was, well, 2010 to 2020 was pretty much straight up, yeah. 2015, Q4, 2018, not great. But it was a robust bull market. You just had to be invested and not make mistakes. So maybe people weren't fully invested, maybe they made some mistakes over that decade. The underperformance was almost triple in the 2000s. And so you're coming off of the dot com implosion. So my experience, I just know firsthand, a lot of people entered 0203 wildly underinvested. They panicked out. In 0809, we saw a capitulation. The bottom formed in March 09. Capitulation means surrender. People panic sold in 09. And there's another study I reference in the book that says when people panic, sell about a third of them, never return to equities. So if you want to know how you underperform by 5, 6% in 10 years, hey, tap out and miss the entire recovery that followed. From March 09 forward, introducing the new.

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Jason Moser (18:59)

Yeah, I was fascinated at that statistic that so many people just don't even bother getting back in. I was kind of taken back by that. And one of the things I really enjoyed about the book, I enjoyed the psychology, the behavioral aspects of it. And I like that you dug into the Dunning Kruger effect. And so for those who are unfamiliar, can you explain what the Dunning Kruger effect is and how it applies to investors?

Barry Ritholtz (19:22)

It's funny because I dropped a little. I have family at University of Michigan, so I dropped a little footnote and I'm shocked at how many people picked up on the Go Blue reference. So David Dunning and his University of Michigan psychology professor and his grad student Justin Krueger did a study to determine if our metacognition, which is a fancy word for how good are we at evaluating our own skill set? Right. And the assumption tends to be that if you're good at something, you're pretty good at evaluating that skill set. And it's not quite right, it's not quite a one for one curve. In the beginning, our metacognition of our skill set when we have really poor skills is awful. And even as we continue to develop skills in that, we're still far, far below where the experts are. It's more than just overconfidence, it's how hard can it be? You know, I love asking a room full of people, how many people here are above average drivers? You know, three quarters of the hands in the room go up, maybe more. And you know, I'm a car guy. I've taken every high performance advanced driving class there is and they're all just thinly disguised defensive driving classes that try and teach you. Stay within your own ability, stay within the car's ability, and if you operate within yourself, if you make fewer mistakes, you'll just do so much better. So Dunning Kruger is not only the tendency for us to misevaluate our skill set and under appreciate how difficult a subject is, but then when you go to the other end of the scale and you talk to experts and you have them self evaluate, they know how difficult things are, they tend to underestimate their own skill set because they're aware of how random the world can be, how challenging and complex things are, that everything you do is dynamic and affects everything else. And then there's this feedback loop. And so the idea of Dunning Kruger is our ability to self evaluate improves over time. And it starts out really bad and eventually catches up as our skills get, get better. Now apply this to investing. Look at what took place during the pandemic with newbie traders and the checks that had gone out from the government and meme stocks and just, hey, how hard can this be? Those guys are a bunch of idiots. I could do this better than them. And so you see like just the classic errors more than overconfidence, where the species as a whole is overconfidence. We can't help it if we weren't, you know, wait, a bunch of us are going to go down with sticks and try and take down that mammoth. The cave that's overconfident goes down and does that and they have fur and meat for the weekend, for the winter. Hey, maybe not everybody else comes back to the cave, but most of us are going to do better. The folks that lack that initiative tended not to survive. And so pop psychology 100 evolutionary biology, we have this tendency to a bias towards action. Of course I think we could do this. Why wouldn't I? How hard can it be? And so that bias towards action leads us to doing things perhaps beyond our own ability. Takes a while for your metacognitive skills to actually develop so that it's not just that you have really good skills, it's that you're really good at evaluating where you are on that scale.

Andy Cross (23:03)

Well, great words of wisdom from Barry Ritholtz. The book is how not to Invest. Barry Ritholtz, thank you so much. Really appreciate it.

Barry Ritholtz (23:10)

Oh, my pleasure. Thanks for having me, guys.

Matt Greer (23:13)

As always. People on the program may have interest in the stocks they talk about, and the Motley fool may have formal recommendations for or against. So don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. For the Motley fool money team, I'm Matt Greer. Thanks for listening and we will see you tomorrow.