Investing without blind spots

Christine Kashkari: Welcome to Better Vantage by Vanguard, a podcast series co-hosted by Custom Content from WSJ and Vanguard. In this podcast series, we will be talking about issues that are top of mind for financial advisors and investors today. In each episode, we'll be sharing market analysis, data, and insights, as well as strategies to help you invest with greater conviction.

And with me today is our co-host, Joe Davis, Vanguard's global chief economist, yes, and resident expert.

Joe Davis: I don't know that, but thrilled to be here, Christine.

Christine: Great to be back with you.

And of course, for this episode, we have our special guest who is Vanguard's head of behavioral economics research, Andy Reed.

Andy Reed: Thanks so much. Happy to be here.

Christine: And Joe, today, this episode is going to be really revealing as only the study of human behavior can be.

Joe: Well, again, it's a high bar Andy. But I think I'm really excited about today. I get to work with Andy. I think it's, you know, I think a little bit like Halloween. A lot of tricks and treats here because there's a lot of things that Andy has brought to my intention for me as an investor grounded in science.

And what I think the listeners are going to get are actionable things that either you can do or perhaps you haven't mastered, but friends and family can do to either minimize losses at the margin or actually make more money.

Christine: No pressure, Andy. *laughs*

Andy: None taken.

Christine: But Andy, Vanguard's 50 million investors really give you incredible visibility and data into what investors are doing at any given moment. But you're all about the why, right? And the how. Can you talk a little bit about that?

Andy: Yeah, it's a great question. So, you know, when we observe behaviors, whether it's good, bad, or ugly, whether it's intentional behavior or errors of omission, let's say, the question is always why did they make the choice they did? And I think that's the fundamental question at the heart of behavioral economics is why do people act the way they do? And in particular, why do they deviate from what the likes of Joe and other economists …

Joe: Because I was supposed to be rational.

Andy: No, not, not necessarily what economists would do, but what economists believe people do. And it turns out that when behavioral economists started looking at actual behavior by actual people in the actual world, they don't follow the models.

Our job is to really sort of identify the gaps between what the likes of economists say is the normative thing to do, whether it's, you know, how you should invest, how you should save, where you should hold cash, etc., and what people actually do with their real money in the real world.

Christine: What actual value has this field added for investors?

Andy: I'll kind of call out one of the greatest applications of behavioral economics to drive better choices. And this was the Save More Tomorrow program. And the idea was, they observed all these, let's say missed opportunities for 401(k) participants to save and invest for retirement. And what they realized is a lot of it boils down to inertia, or, let's call it economic impatience. So people would rather have more money now and forgo more money later. So they're kind of more likely to spend now as opposed to save for the future.

And so what they did is rather than try to fix the person, the key insight was let's fix the environment, let's fix the decision architecture so that the right choice is the easy choice. And in fact, it's the default or automatic choice.

So rather than trying to educate people and convince them and persuade them, which is really quite challenging, they automated enrollment in the 401(k) plan. They automated investment through a target-date fund, and they automated increases in the savings rate over time.

And they basically estimate this is probably a trillion dollars worth of additional retirement.

Joe: Trillion with a T?

Andy: Trillion with a T, in fact. So, it's probably the single greatest application of behavioral economics and it's one that Vanguard was at the heart of from the early days.

Joe: Do you see behavior of investors in your judgment acting too fast or do you see the opposite?

Andy: I think in this case, we see risks at opposite ends of the spectrum. So going too fast, if you're making impulsive, knee-jerk reactions to, for example, market volatility or the latest news headlines, there's a risk that you won't take into account the full picture. That you might focus on the near term and kind of alleviating maybe some stress, some anxiety in the here and now and causing the high potential for regret down the road.

The other end of the spectrum that we see is it's less about thinking too slow. It's about not thinking or not engaging at all.

Christine: I feel like there are more people probably on the "do nothing" spectrum.

Andy: There's a lot, absolutely. What we find, in particular, we find cash sitting in retirement accounts where you wouldn't expect it and where economists just say it does not belong.

Imagine a 25-year-old who had their first job, they worked there for let's say three years straight out of college, and they do a rollover, and they roll the 401(k) assets into an IRA. It turns out that many of them, if not most of them, leave it in cash for extended periods of time.

In our research, we found that often up to seven years or more. So talk about going too slow. And meanwhile the market’s, you know, hitting all-time highs.

Joe: It could be hundreds of thousands of dollars over a lifetime of someone.

Andy: Absolutely. Yeah. So it's sort of the opportunity cost, as you said before, you know, missed gains essentially. So that's one end of the spectrum.

Christine: But let's talk about these biases. Let's go into them more in depth because you do a lot of research on blind spots. And we want to talk about them and see if our listeners, our viewers can recognize any of these in themselves or in somebody that they know.

Andy: It's tricky. To be fair, I'm an expert in what people do wrong, not what they should do right. So, I'm not in a position to give financial advice in that way. But certainly, you know, you mentioned blind spots.

The dilemma is this—it's a black box. We make the choice. And then you ask people, why did you do that? And they go,  "I don't know." One implication of this is that many of these biases that we demonstrate, we're not even aware of them, right? So loss aversion, the average person doesn't realize that they react more strongly to losses than to gains, but they do.

Joe: What are some of the things I'm not taking advantage of if I have those tendencies?

Andy: So this is the funny thing. Tax loss harvesting is this fascinating optimization strategy that, economists would say, like absolutely it's a no brainer. But it goes against human nature, because you're trying to convince someone to lock in a loss when their motivation is to avoid losses. And they're more motivated in many cases to avoid losses than they are to seek gains.

So it's really paradoxical, right? You're saying you'll come out ahead if you lock in a loss.

Christine: So how do you bridge that? How do you incentivize or how do you design a strategy around that?

Andy: Asking people to tax loss harvest on their own devices, it's probably unlikely, but if you make it a really easy option, and Vanguard actually in the past couple of years has done that, where when people are placing a sell order, we give them the option that's literally called MinTax and it says minimize your tax burden, which is kind of…

Joe: Versus first in, first out.

Andy: Exactly. Yeah, first in, first out is kind of the classical default and a lot of people go with it because of inertia, but that's essentially the equivalent of MaxTax in many cases.

Christine: I love where we're going with this. Why don't we talk about recency bias. And the same thing, what is it? I think there's a FOMO, performance chasing, rear-view mirror investing are all rolled into that. Can you talk about that?

Andy: Yeah, the 24-hour news cycle, right? It has to do with the half-life of memory, fundamentally. So the idea is when you get people to think about the future or make decisions that implicitly integrate some prediction about the future, like, well, I'm going to increase my equity exposure. So I think the stock market's going to go up. What weighs most heavily in those judgments and decisions is the thing that's most accessible, the thing that's top of mind.

The more recent it is, all else equal, the more available it is to your memory and the more weight it carries in your judgments and decisions. Every two months, and Joe's familiar with this research, we asked about 2,000 investors to predict the future of the market, the GDP growth.

We asked them to play Joe Davis essentially. *laughs

Joe: They actually do pretty well.

Andy: We've done this for, you know, 7 or 8 years now, every two months. So consistently we have this longitudinal data set and we can look at their expectations. 12 months was the sweet spot. Trailing 12-month returns were the best predictor of forward 12-month returns in the mind of the investor. Despite all of our warnings. Past performance is no guarantee …

Joe: It’s very low correlation, sometimes negative in some markets. You see anything on the trading front too, right? Is there activity that's too much activity? What I mean by that, I'm selling an active ETF and I'm buying discretionarily a new ETF or mutual fund.

Andy: One of my favorite paper titles of all time is Trading is Hazardous to Your Wealth.

And basically what they showed is that the people who trade more actively have worse performance, worse returns. So they're undermining their long-term goals. Now, you might argue, well, maybe they're garnering some emotional utility. Maybe it's just fun. But you know, there's a difference between a little bit of trading with a little bit of your portfolio and then making risky bets with your nest egg on a regular basis.

The good news is, at least when we look at Vanguard data, and going back to your point-- we got 50 million investors, a lot of data to look at, we don't see much evidence of overtrading, right? If anything, the risk that we see is people that aren't rebalancing, that aren't taking advantage of opportunities, that are sticking with cash for too long in a long-term retirement account.

Christine: How can the industry best encourage or incentivize again, these investors, whether you're an overactive trader or you're somebody that does nothing with your portfolio to prepare them for the next 10 years?

Andy: The good news is a lot of investors are sort of building these portfolios that are kind of all- weather, right? So the ups and downs in the market, no problem. In the 401(k) space, I think that the adoption of TDFs has been just a game-changer.

Joe: Target-date funds.

Andy: Yeah. You know, prior to target-date fund defaults, you looked at the equity allocation for younger versus middle-aged versus older investors, all over the map. A lot of people had all cash, a lot of people were 100% company stock. So they had these either way too risky or way too conservative portfolios. And in some cases people were reacting to the market, but in many cases they were just oblivious to what was going on.

With target-date funds, you have portfolios that adjust. So if the market goes down, you know, there's automatic rebalancing, and the market goes up, it automatically rebalances. And so it kind of adapts over time to these changing market conditions.

So too with advice. I think that a lot of people don't enjoy investing. I think the folks in this industry are kind of the exception to the rule. But for many people, investing is something that you kind of have to do, but it's not necessarily something that you derive joy from, let alone something that you're an expert in.

Let's be clear, being an expert in investing is rare. It's the exception to the rule. The average American lacks foundational knowledge. So on that side of the spectrum, you've got people who are sort of, let's say, unskilled and unaware. So they're overconfident. They think they know everything, make really risky bets. They make more trades and they get, you know, worse performance. But then there's the folks who are unskilled and aware, right? And they realize, like, I don't know what I'm doing. Unfortunately, a lot of the sort of dominant response in many cases is disengagement. That's incredibly risky. And I think that's where you get a lot of people who just say, you know, investing is not for me.

Joe: And will you see a lot of cash drag there?

Andy: Yeah, we see they have lower levels of equity in their portfolio and it's statistically meaningful. It's like 8% give or take. I'd have to double check the research…

Joe: But over time that can compound, right?

Andy: Hugely. Well, and it's the difference where like if you were 8% off track from your target glide path, you would rebalance. So it suggests maybe there's an opportunity there.

Christine: I hate to ask you for your favorite, but which of these behaviors have you seen impact investment outcomes the most?

Andy: I have to say inertia and status quo bias. I think it's just, again, most people do nothing almost all the time. And you know, it doesn't matter whether it's your 401(k), your IRA, your HSA and brokerage account, you name it. And the question is what's happening while you're doing something else?

And by the way, it's often not willful inertia. It's just, you're dealing with life. You're doing a podcast, right?

Joe: Never got around to it, changed my job…

Andy: Procrastination.

Joe: We were talking with Fiona a few episodes ago with the job change every three or four years.

Andy: Exactly. And I think it's these moments that matter. The life transitions, the events, you know, new job, new baby, you retire, windfall gain. There's a lot of these events that happen. I think it's on the choice architect.

So it's on the Vanguards of the world to create menus that make it easy, that make it simple, that make it fast, that make it effortless. And it's sort of, you know, satisfies your desire to take the happy path.

As you may recall, when Fiona Greig was here in the episode on retirement, she talked about when people switch jobs, their savings rate declines. They get a raise, but they save less. Why is this? It's because they get sort of anchored on this new default or new savings rate, and they don't port over the old one. So a simple way to change the anchor, you just ask people, what were you saving in your last job? And people could tell you a lot of times they're like, oh, you know, saving, you know, 10, 12, 13 percent. It's all right, let's prefill that and go from there.

Joe: What I'm hearing from you, listen, there’s some of the too-fast behavior and the too-slow. I got to be honest, I would have thought the too fast was the dominant of the population, but I'm hearing you say no, there's actually the too slow and there's things around cash drag and the faults that, I don't know, I almost took for granted. Maybe it sounds like I had a bias that's actually the greater opportunity for potentially, if our listeners are a swath of the random population. So that's something that sounds like a checklist to do.

And then the second one was related to that just in terms of the inertia and then the expertise.

Andy: You know, often times with your portfolio, it's not like you have five minutes to make a life-or-death decision. That's incredibly rare. But there are these moments that matter that come up where like you really should make a choice and you should think about it and you should make the right choice because if you go down the wrong path over time, you're going to be in a much worse position.

Christine: Is there a design for that, that prompts you, that you better look at it now for the next five days?

Joe: Yeah, give me some of the moments that matter.

Andy: I mean, you know, a lot of times, and this is something that Vanguard is increasingly developing sort of tools, technology, using AI, among other things, to really personalize. How do you nudge people when you know something's going on?

Hey, they're sitting on a bunch of idle cash in their retirement account. And we've been nudging them and we've been sending them personalized messages and we've actually been able to get billions of dollars out of idle cash and into the market working for people.

Christine: As we wrap up today's episode …You've shared a lot of insights and hopefully people recognize themselves, recognize that there is a solution, what would be the key takeaways?

Andy: Check your blind spots. Just again, like in driving, if you change lanes without checking your blind spot, you're going to have a bad time. So I think just looking at your account and making sure, is this what you intended it to be?

Because either you forgot or maybe the market drifted and that 60/40 portfolio that you set up so carefully and deliberately 10 years ago is now, I don't know, 80/20 and you didn't want it to be 80/20, but you didn't realize how drift works.

So I think it's a little bit like, if you haven't looked in your fridge in a few weeks, you might want to take a look, maybe do a little bit of spring cleaning. That's a bad analogy.

Joe: I don't know. *laughs. That’s going to stick with me though. So the fridge, if you haven't opened it in three or four weeks…

Andy: Maybe it’s the back of the freezer.

Joe: So it's not logging on every day. But let's not leave good hard-earned dollars not working for us.

Christine: Thank you so much, Andy, for all the terrific insights that you shared with us today.

Andy: Thanks so much.

Christine: If you enjoyed this episode and found it helpful, subscribe and share.