Behavioural Investing

A Practitioner's Guide to Applying Behavioural Finance

James Montier

• Publisher: Wiley
• Year: 2009
• ISBN:
  9780470687796
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Behavioural investing seeks to bridge the gap between psychology and investing. All too many investors are unaware of the mental pitfalls that await them. Even once we are aware of our biases, we must recognise that knowledge does not equal behaviour. The solution lies is designing and adopting an investment process that is at least partially robust to behavioural decision-making errors.

Behavioural Investing: A Practitioner's Guide to Applying Behavioural Finance explores the biases we face, the way in which they show up in the investment process, and urges readers to adopt an empirically based sceptical approach to investing. This book is unique in combining insights from the field of applied psychology with a through understanding of the investment problem. The content is practitioner focused throughout and will be essential reading for any investment professional looking to improve their investing behaviour to maximise returns. Key features include:

• The only book to cover the applications of behavioural finance
• An executive summary for every chapter with key points highlighted at the chapter start
• Information on the key behavioural biases of professional investors, including The seven sins of fund management, Investment myth busting, and The Tao of investing
• Practical examples showing how using a psychologically inspired model can improve on standard, common practice valuation tools
• Written by an internationally renowned expert in the field of behavioural finance

SECTION IV

Investment Process as Behavioural Defence

18

The Tao of Investing

If the previous section outlined the major failings of the average institutional investment process, this section attempts to outline an investment process that is at least partially robust to behavioural biases. It focuses on a contrarian or value-oriented approach to investing. Topics covered include the traits of best fund managers, the evidence in support of value, and why risk is a four-letter word.

• The evidence from over three decades of behavioural decision-making research contains a rather unpleasant findings that simply being aware of our biases is not enough (although obviously an important first step). Rather than relying upon self-insight to change behaviour, a better solution would appear to codify behavioural rules into an investment process.

• The chapters contained in this section aim to explore how we might pursue investment strategies that are at least partially robust to some of the behavioural problems identified in the earlier chapters. The papers collected here can be broken into three distinct (but related) areas.

• Part A deals with what it takes to be a successful investor. The chapters collected here cover areas as diverse as the traits shared by long-term successful value investors, the need to be prepared to take off-index positions, the investment advice of Ben Graham and John Maynard Keynes, and advantages offered by the use of quant models in investing. The final chapter in this part deals with why a value-oriented approach is likely to be a logical one going forward. It deals with the behavioural stumbling blocks that prevent otherwise sensible investors from doing what is right.

• Part B takes the perspective of an empirical sceptic. One of the key behavioural mistakes covered in the seven sins was believing stories. In order to avoid this pitfall, this part subjects the value approach to an empirical assessment. The chapters included here cover such topics as why value works (in terms of the margin of safety), improvements to basic value strategies such as using Joel Greenblatt’s little book strategy, incorporating information from external finance, and using Graham and Dodd style PEs. We also explore the critical role that time horizon plays in investing. Patience is a virtue for value investors but an absolute nightmare for growth investors.

• Part C tackles the nature of risk. Risk is an integral part of the investment process, but probably a badly understood one. According to classical finance, risk is defined as price volatility. However, never yet have we met a long-only fund manager who cares about upside risk, strangely enough this gets lumped into return and is lauded. The chapters in this part explore the failure of price volatility and beta as measures of risk, and indeed the failures of risk managers (who would be better labelled as risk maniacs).

The seven sins of fund management (November 2005) represented a psychological critique of a ‘typical’ large fund management organizations investment process. As such it largely constituted a list of don’ts. This collection aims to be a list of do’s.

As all investors are aware, we can’t control return (would that we could). Instead we have to concentrate on the investment process. Our aim in this volume is to collect together some of the various notes we have written on how to invest.

An interesting article in the Journal of Investing by John Minahan (2006) helps to frame the debate that this collection aims to address. Minahan argues that a sound investment philosophy is vital in distinguishing alpha⁵⁴ from noise. He argues that managers are more likely to outperform if they:

1. Have a clear thesis of how they generate alpha. Managers are not likely to generate ex-ante alpha without having a very clear idea of what they do that generates alpha, what it is about the markets they invest in that provides the opportunity to generate alpha, and what their competitive advantage is in exploiting that opportunity.

2. Put significant effort into understanding where their performance comes from. Good managers recognize that they have as much stake as anybody in understanding whether their performance is due to the successful execution of the alpha thesis, benchmark misfit, or luck, and are therefore very thoughtful about evaluating their own performance.

3. Have thought about whether their alpha-generation process will need to change over time. In competitive capital markets, alpha-generation sources tend to be arbitraged away. Good managers understand this, and therefore monitor whether or not it is happening, and have a process for seeking out new alpha sources which lever the manager’s competitive advantage.

These three questions frame the selection of chapters we have chosen here. Part A deals with why it is vital to do something different from the vast majority of investors. As Sir John Templeton said, “It is impossible to produce a superior performance unless you do something different from the majority.”

The chapters in Part A cover areas as diverse as the traits shared by long-term successful value investors, the need to be prepared to take off-index positions, the investment advice of Ben Graham and John Maynard Keynes, and advantages offered by the use of quant models in investing. The final chapter in this part deals with why a value-oriented approach is likely to be a logical one going forward. It deals with the behavioural stumbling blocks which prevent otherwise sensible investors from doing what is right. This, of course, speaks directly to the third of Minahan’s requirements listed above.

Part B takes the perspective of an empirical sceptic. One of the key behavioural mistakes covered in the seven sins was believing stories. In order to avoid this pitfall, this part subjects the value approach to an empirical assessment.

The chapters included in Part B cover the such topics as why value works (in terms of the margin of safety), improvements to basic value strategies such as using Joel Greenblatt’s little book strategy, incorporating information from external finance, and using Graham and Dodd style PEs. We also explore the critical role that time horizon plays in investing. Patience is a virtue for value investors but an absolute nightmare for growth investors.

We then turn to look at varieties of value in terms of whether it is best defined at the stock or sector level. We also show the evidence that value works best when considered relative to industry (so-called sector neutral strategies). We also show that value and momentum can be used to aid country selection - so a value spin on GTAA if you like.

Part C tackles the nature of risk. Risk is an integral part of the investment process, but probably a badly understood one. According to classical finance, risk is defined as price volatility. However, never yet have we met a long-only fund manager who cares about upside risk; but strangely enough this gets lumped into return and is lauded. The chapters in this part explore the failure of price volatility and beta as measures of risk, and indeed the failures of risk managers (who would be better labelled as risk maniacs).

We hope that these chapters at least provide some response to Minahan’s criteria for assessment, as well as providing an outline for a psychologically robust investment process that seeks to avoid many of the pitfalls detailed in the seven sins of fund management.

PART A

The Behavioural Investor

19

Come Out of the Closet (or, Show Me the Alpha)⁵⁵

Occasionally, the underperformance of fund managers vs the index is trotted out as evidence of the efficiency of the market. However, this confuses the absence of evidence with evidence of the absence. A new study suggests that closet indexing accounts for nearly one-third of the US mutual fund industry. Stock pickers account for less than 30% of the market, yet they have real investment skill.

• The fact that most...