The Little Book of Behavioral Investing

How not to be your own worst enemy

James Montier

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470712030
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Inversiones y valores

A detailed guide to overcoming the most frequently encountered psychological pitfalls of investing

Bias, emotion, and overconfidence are just three of the many behavioral traits that can lead investors to lose money or achieve lower returns. Behavioral finance, which recognizes that there is a psychological element to all investor decision-making, can help you overcome this obstacle.

In The Little Book of Behavioral Investing, expert James Montier takes you through some of the most important behavioral challenges faced by investors. Montier reveals the most common psychological barriers, clearly showing how emotion, overconfidence, and a multitude of other behavioral traits, can affect investment decision-making.

• Offers time-tested ways to identify and avoid the pitfalls of investor bias
• Author James Montier is one of the world's foremost behavioral analysts
• Discusses how to learn from our investment mistakes instead of repeating them
• Explores the behavioral principles that will allow you to maintain a successful investment portfolio

Written in a straightforward and accessible style, The Little Book of Behavioral Investing will enable you to identify and eliminate behavioral traits that can hinder your investment endeavors and show you how to go about achieving superior returns in the process.

Praise for The Little Book Of Behavioral Investing

" The Little Book of Behavioral Investing is an important book for anyone who is interested in understanding the ways that human nature and financial markets interact."
— Dan Ariely, James B. Duke Professor of Behavioral Economics, Duke University, and author of Predictably Irrational

"In investing, success means¿being on the right side of most trades. No book provides a better starting point toward that goal than this one."
— Bruce Greenwald, Robert Heilbrunn Professor of Finance and Asset Management, Columbia Business School

"'Know thyself.' Overcoming human instinct is key to becoming a better investor.¿ You would be irrational if you did not read this book."
— Edward Bonham-Carter, Chief Executive and Chief Investment Officer, Jupiter Asset Management

"There is not an investor anywhere who wouldn't profit from reading this book."
— Jeff Hochman, Director of Technical Strategy, Fidelity Investment Services Limited

"James Montier gives us a very accessible version of why we as investors are so predictably irrational, and a guide to help us channel our 'Inner Spock' to make better investment decisions. Bravo!"
— John Mauldin, President, Millennium Wave Investments

Chapter One

In the Heat of the Moment

Prepare, Plan, and Pre-Commit
to a Strategy

 

 

 

 

 

 

EMOTIONAL TIME TRAVEL ISN’T OUR SPECIES’ FORTE. When asked in the cold light of day how we will behave in the future, we turn out to be very bad at imagining how we will act in the heat of the moment. This inability to predict our own future behavior under emotional strain is called an empathy gap.

We all encounter empathy gaps. For instance, just after eating a large meal, you can ’t imagine ever being hungry again. Similarly, you should never do the supermarket shopping while hungry, as you will overbuy.

Now let’s imagine you are lost in some woods. As you search though your backpack you discover that you have forgotten to bring both food and water. Oh, the horror. Which would you regret more: not bringing the food or the water?

Psychologists⁵ have asked exactly this question of two different groups and offered them a bottle of water in return for participating. One group was asked just before they started to work out at a gym; the other group was asked immediately after a workout. If people are good emotional time travellers, the timing of the questions should have no impact at all. However, this isn ’t the pattern uncovered by the researchers. Sixty-one percent of the people who were asked before the workout thought they would regret not taking water more. However, after the workout, 92 percent said they would regret not taking water more!

My all-time favourite example of an empathy gap comes from an experiment by my friend Dan Ariely and his co-author George Loewenstein.⁶ They asked 35 men (and it had to be men for reasons that will become all too obvious) to look at pictures of sexual stimuli on a cling- film-wrapped laptop. To save the gentle readers ’ blushes I have omitted the full list, but suffice it to say that acts such as spanking and bondage were included.

The subjects were asked to rate how much they would enjoy each act while in a cold state (in front of an experimenter in a classroom- like environment). The participants were then sent home and asked to reevaluate the pictures in the privacy of their own home while enjoying what might be delicately described as self-gratification.

In the cold light of day the average arousal rating was 35 percent. However, this rocketed to 52 percent when the men assessed the images in a private, aroused state. That is a massive 17 percentage point increase, driven by the heat of the moment!

The Perils of Procrastination

In order to see how we can combat empathy gaps, we must first look at the perils of procrastination—that dreadful urge you suffer, when you know there is work to be done, to put it off for as long as possible.

Imagine you have been hired as a proofreader for a set of essays, each about 10 pages long. You have three options: You can set your own deadlines and turn in each essay separately; you can hand everything in at the last minute before a final deadline; or you can go with a predetermined set of deadlines for each essay. Which would you choose?

Most people (myself included, of course) go with handing everything in at the last moment. After all, we reason, I ’ll do the work at my pace and then hand it all in whenever I like.

Unfortunately, this decision ignores our tendency to procrastinate (something book editors will be all too familiar with!). While we all start off with the best of intentions to space out the work evenly, inevitably other things come up, our best-laid plans are disrupted, and we end up doing all the work at the last minute.

Yet, psychologists have found⁷ that imposed deadlines are the most effective. Researchers split people into three groups randomly and assigned them one of the conditions outlined above. Those who were told they had to follow equally spaced deadlines found the most errors, yet handed their work in with the least delay. The group who chose their own set of deadlines found fewer errors and were nearly twice as late handing in their reports. However, the worst -performing group was those who were allowed to wait until the final deadline to hand everything in. This group found far fewer errors than the other two groups and were nearly three times later in handing in their reports than those who worked to equally spaced deadlines. This experiment provides a possible weapon to place in our arsenal against the behavioral pitfall of empathy gaps and procrastination—pre-commitment.

The Power of Pre-Commitment

So what can we, as investors, do to prevent ourselves from falling into these emotional time travel pitfalls? One simple answer is to prepare and pre-commit. Investors should learn to follow the seven P’s—: Perfect planning and preparation prevent piss poor performance. That is to say, we should do our investment research when we are in a cold, rational state—and when nothing much is happening in the markets—and then pre-commit to following our own analysis and prepared action steps.

Sir John Templeton, legendary investor and mutual fund pioneer, provides us with a perfect example of this process in action. He was well known for saying “The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell. ” Few would disagree with the sentiment. However, when “everyone is busy despondently selling,” it can be hard to stand against the tide and buy. This difficulty is the very definition of an empathy gap.

Sir John’s great -niece, Lauren C. Templeton, provides us with the strategy her uncle used to overcome this obstacle in her book, Investing the Templeton Way:

There are clear psychological challenges to maintaining a clear head during a sharp sell off. One way Uncle John used to handle this was to make his buy decisions well before a sell off occurred. During his years managing the Templeton Funds, he always kept a “wish list” of securities representing companies that he believed were well run but priced too high . . . he often had standing orders with his brokers to purchase those wish list stocks if for some reason the market sold off enough to drag their prices down to levels at which he considered them a bargain.

This prime example of pre-commitment in the face of a known empathy gap is exactly what you should seek to emulate in your investment strategies. Sir John knew that on the day the market or stock was down say 40 percent he wouldn ’t have the discipline to execute a buy. But, by placing buy orders well below the market price, it becomes easier to buy when faced with despondent selling. This is a simple but highly effective way of removing emotion from the situation.

Chapter Two

Who’s Afraid of the Big Bad Market?

Re-Investing When Terrified

LET’S PLAY A SIMPLE GAME. At the start of the game you are given $20 and told the following: The game will last 20 rounds. At the start of each round you will be asked if you would like to invest. If you say yes, the cost will be $1. A fair coin will then be flipped. If it comes up heads you will receive $2.50. If it comes up tails, you will lose your $1.

Now there are two things we know about this game. First—and perhaps most obvious—it is in your best interest to invest in all rounds due to the asymmetric nature of the payoff. That is to say, you stand to make more than you lose in each round; the expected value per round is $1.25, giving a total expected value to the game of $25. In fact, there is only a 13 percent chance that you’d end up with total earnings of less than $20, which is what you’d have if you chose not to invest at all and just kept the initial endowment. The second thing we know is that the outcome in a prior round shouldn’t impact your decision to invest in the next round—after all, the coin has no memory.

However, when experimenters studied this game they found some very unusual behavior.⁸ They asked three different groups to play the game. The first group was very unusual; they had a very specific form of brain damage—these individuals couldn’t feel fear. The second group of players were people like you and me—ostensibly without any evidence of brain damage. The third group consisted of people who had brain damage but in parts of their brains unrelated to the processing of emotion (and hence fear).

Who do you think fared best? Not surprisingly, it was the group with the inability to feel fear. They invested in 84 percent of rounds, whereas the so-called normals invested in 58 percent of rounds, and the group with non- fear- related brain damage invested 61 percent of the time.

The group who couldn’t feel fear displayed their real edge after rounds in which they had lost money. Following such rounds, they invested more than 85 percent of the time—pretty optimal behavior. This was a huge contrast with the other two groups, who displayed seriously sub-optimal behavior. In fact, so bad was the pain/fear of losing even $1 that these groups invested less than 40 percent of the time after a round in which they had suffered a loss.

You might think that, as time went on, people would learn from their mistakes and hence get better at this game. Unfortunately, the evidence suggests a very different picture. When the experimenters broke the 20 rounds down into four groups of five games, they found that those who couldn’t feel fear invested a similar percentage of the time across all four groups. However, the normals started off by investing in about 70 percent of the rounds in the first five games, but ended up investing in less than 50 percent of the final five games. The longer the game went on, the worse their decision-making became.

You may be wondering why I am telling you this story—well, it naturally parallels the behaviors investors exhibit during bear markets. The evidence above suggests that fear causes people to ignore bargains when they are available in the market, especially if they have previously suffered a loss. The longer they find themselves in this position, the worse their decision- making appears to become.

Of course, this game is designed so that taking risk yields good results. If the game were reversed and taking risk ended in poor outcomes, the normals would outperform the players who can’t feel fear. However, the version of the game outlined above is a good analogy to bear markets with cheap valuations, where future returns are likely to be good.

Brain Drain and Performance

A recent study⁹ explored the same game that is outlined above, but measured people based on their degree of reliance upon X-system thinking. (For those interested in the testing format, they used a self-report approach. People were measured on the basis of how much they agreed or disagreed with eight statements, such as “I tend to use my heart as a guide for my actions, ” “I like to rely on my intuitive impressions, ” and “I don’t have a very good sense of intuition,” rather than a more clinical approach like the CRT that we used in Chapter 1.) It was surmised that if the depletion of mental resources such as self-control is a problem, then those who rely more on their X-system should suffer poorer decision- making when they have been forced to use up their store of self -regulatory ability. To put it another way, those who use their quick and dirty thinking systems (X-system thinking) will run out of self-control faster than those who are more inclined to use their logical thinking systems (C-system thinking).

In order to achieve this, one group of players was subjected to a Stroop test. The Stroop test will be familiar to fans of brain training games, although they may not know its name. It presents the names of colors, and players have to name the color in which the name of the color is written, rather than the name of the color. Thus the word RED may appear in blue ink, and the correct response is blue. It thus takes concentration and willpower to complete the Stroop test.

When the game was played with a pre-test (i.e., without the Stroop test), both those who relied on X- and C-system processing performed in the same fashion. They invested about 70 percent of the time (still distinctly sub-optimally).

However, the results were very different when people were unable to control their own fear and emotions (i.e., after the Stroop test). Those with a very strong reliance on their C-system continued to do well, investing 78 percent of the time. However, those who relied heavily on their X-system suffered particularly badly. They invested only 49 percent of the time! This is yet more evidence of the dangers of relying upon our own abilities to defeat our decision-making demons.

The Cure for Temporary Paralysis

In March 2009, the S&P 500 swooned to its lowest levels in a decade, and the market had declined some 57 percent since its peak in late 2007.

I watched as markets seemed to be near meltdown. No scenario seemed to be pessimistic enough to be beyond belief among investors. How did this make me feel? Actually, very excited. Not because I have some sick perversion that means I enjoy a crisis (although I may well), but rather because markets were getting cheap. As I wrote in Mind Matters in early March 2009, “Buy when it’s cheap—if not then, when?” The basic argument was simple enough: Markets were at levels of valuation that we simply hadn ’t seen for 20 to 30 years. Of course, valuation isn’t a fail-safe reason for buying equities—cheap stocks can always get cheaper—but in March I was convinced that they offered a great buying opportunity for long-term investors.

I wasn’t alone in thinking these thoughts. Jeremy Grantham, chief strategist of GMO, penned the following:

As this crisis climaxes, formerly reasonable people will start to predict the end of the world, armed with plenty of terrifying and accurate data that will serve to reinforce the wisdom of your caution. Every decline will enhance the beauty of cash until, as some of us experienced in 1974, “terminal paralysis” sets in. Those who were over invested will be catatonic and just sit and pray. Those few who look brilliant, oozing cash, will not want to easily give up their brillia...