Success in investing doesn’t correlate with IQ once you’re above the level of 100, writes Warren Buffett, “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
That statement from Buffett highlights the importance of human behaviour in investing. And the study of behaviour in the context of investing is what behaviour finance is all about. In today’s world of information technology where access to information is not really a privilege anymore, what has become increasingly more crucial to investing performance is how one controls his own behaviour and emotions especially during the time of market extremes i.e., bull and bear markets.
There are hundreds of book out there which talk about behavioural finance. For any new investor this can get overwhelming. For such people, one of the best place to wet their feet is to start with James Montier’s book The Little Book of Behavioural Investing.
Montier is an outspoken value investor and member of the asset allocation team of Boston-based GMO. GMO has more than US$ 100 billion of assets under management. Prior to GMO, he was the co-Head of Global Strategy at Société Générale. He has written three other books on value investing and behavioural finance.
In Montier’s own words, here’s what can you expect from this book –
..I will highlight some of the most destructive behavioral biases and common mental mistakes that I’ve seen professional investors make. I’ll teach you how to recognize these mental pitfalls while exploring the underlying psychology behind the mistake. Then, I show you what you can do to try to protect your portfolio from their damaging influence on your returns. Along the way, we’ll see how some of the world’s best investors have striven to develop investment processes that minimize their behavioral errors.
So without further ado, here are few ideas from the book.
Overcoming Empathy Gap with Seven P’s
Every value investor (including myself) likes to repeat Warren Buffett’s quote – “Be greedy when others are being fearful and be fearful when others are being greedy.” But when the panic sets in the market and stocks are down by 40 percent, most of us wouldn’t have the discipline to execute a buy. When the time comes, why do we find it hard to do what we earlier thought we would do under such circumstances? Montier writes –
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.
Empathy gap explains why Buffett’s simple advice is not easy to follow. So what can we do to overcome the perils of empathy gap? The answer is, using the power of pre-commitment. Montier suggests –
Investors should learn to follow the seven P’s – Perfect planning and preparation prevents 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.
The simplest and most effective example of this strategy is investing through SIPs (systematic investment plan). By getting ourselves out of the equation and setting up an automated system of investing a fixed amount of money every month, we remove the risk of underinvestment during panic time and overinvestment during market euphoria.
Guy Spier, in his book The Education of a Value Investor, talks about one such hack. He writes –
When it comes to buying and selling stocks, I need to detach myself from the price action of the market, which can stir up my emotions, stimulate my desire to act, and cloud my judgment. So I have a rule, inspired by Mohnish [Pabrai], that I don’t trade stocks while the market is open. Instead, I prefer to wait until trading hours have ended. I then email one of my two brokers— preferring not to speak with them directly— and ask to trade the stock at the average price for the upcoming day. I’m not trying to get an edge on the market because I don’t want to get swept up in its constant mood swings. As Ben Graham explained, we have to try to make the market our servant, not our master.
Every professional money manager’s goal is to beat the indexes i.e. do better than the average. This compulsion pulls them into the game of trying to predict what average investor would do in the market. It’s an extremely difficult game to play and only a handful of people manage to win in this game.
Perhaps the most striking example of overconfidence among professionals is their general belief, write Montier, “that they can outsmart everyone else – effectively, get in before everyone else and get out before the herd dashes for the exit.” John Maynard Keynes’ wrote this in 1936 –
Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth, and higher degrees.
Keynes’ example illustrates how hard it is to be just one step ahead of everyone else. Still most investors are spending their time doing exactly that – trying to be the smartest person in the room, hoping to get in before everyone else, and to get out before everyone else does. What’s the alternative? How can one invest profitably without trying to outsmart others?
The good news is that, writes Montier, “We don’t need to outsmart everyone else. We need to stick to our investment discipline, ignore the actions of others, and stop listening to the so-called experts.”
Here’s an interesting example how our mind tries to solve problems –
Imagine you are faced with the following sequence of numbers: 2-4-6. Your job is to figure out the rule I used to construct this sequence. To uncover the rule you may construct other sets of three numbers and I will give you feedback as to whether they satisfy the rule I used. If you are sure you have the solution, you may stop testing and tell me what you think the rule is. Most people approach this test by suggesting 4-6-8, to which the response is “Yes, it fits the rule,” then 10-12-14, which again garners a positive response. Many people think they know the rule at this point, and say something along the lines of “Any numbers that increase in increments of two,” or “Even numbers that increase by increments of two,” to all of which the response is, “That isn’t the rule I used to construct the sequences.” In fact, the rule used was “Any ascending numbers,” but very, very few people ever manage to uncover the rule. The easiest way of doing so is to identify sequences that generate the response, “No, that doesn’t fit the rule,” such as a sequence of descending numbers or a mixed order of numbers. But most of us simply don’t think to suggest these kinds of sequences. Again, we are too busy looking for information that confirms our hypothesis
The great philosopher Karl Popper argued that the only way to test a hypothesis was to look for information which can disprove the hypothesis. This is known as proof by falsification. Nassim Nicholas Taleb calls this process – Via Negativa. Taleb uses the example of black swans. He argues that you can’t prove decisively that “all swans are white” by arguing that you have seen thousands of swan which were all white. However, citing of a single black swan can disprove your hypothesis – decisively.
Legendary scientist Charles Darwin was known to employ this trick in his work all the time. He often looked for disconfirming evidence. Every time he came across a fact that seemed to contradict his theory of evolution he wrote it down and tried to figure out how it fit in. Unfortunately, not many investors think like Darwin. So how can we overcome this confirmation bias? Montier suggests –
…we should sit down with the people who disagree with us most. Not so that we will change our minds, because the odds of changing one’s mind through a simple conversation are about a million to one against, but rather so that we can hear the opposite side of the argument. If we can’t find the logical flaw in the argument, we have no business holding our view as strongly as we probably do.
If you’re already aware of various behavioural biases, you may not find any new ground breaking information in this book. However, you should still read Montier’s book for two reasons.
First, human biases are so deep wired in our brains that it takes tremendous will power and intelligent hacks to overcome its effects. Which means human folly is something which needs to be reminded every now and then. The book is a great reminder of the various behavioural pitfalls that we all are prone too.
Second, in spite of the basic principles being same, the examples used by author are quite interesting. Moreover, James Montier, being a successful value investor, has his own experiences and history which brings a unique perspective to the subject of behavioural investing
Finally, remember that there is no secret to reading more. It’s all about the game of setting the right priorities. You just have to change your perception so that reading becomes an extension of who you are and what you do.