Tag: The Little Book of Behavioral Investing

Why promising to be good just isn’t good enough…

This is the close of the The Little Book of Behavioral Investing. I must admit that while I expected the review to be an edifying experience, I didn’t expect it to be such fun. Many thanks to James Montier for making what could have been dreary an engaging, relevant and enriching read.

The book is on its last page but what about you and me? It’s certainly not the end for us, it’s a beginning of our journey to becoming better investors.

And why only investors?

Like I mentioned before, the teachings in this book go far beyond the circle of investors. The wisdom is universal as are the traits that make us a victim of our own biases. And the secret sauce here, as Kung Fu panda realized, is that there’s no secret sauce. The only weapon to defeat all biases is you. Through this book, we can learn the tools and strategy to achieve bias nirvana.

But promising to improve won’t do the magic. In fact, there is no magic, just commitment, perseverance and focus.

Montier admits he’s as bad as the rest. He may keep an investment diary and stick to an investment plan but he’s vulnerable when it comes to his eating habits. If eating is his nemesis, change aversion is mine. And though I realize this trait could hurt me in the long run, I don’t do much about it.

Access to knowledge certainly doesn’t guarantee obeisance.

There are some habits we just don’t want to change. It’s too much trouble or maybe, the outcome of harbouring this habit hasn’t hit us yet. Remember “after loss” versus the “risk of incurring a loss” behaviour?

Till the worst hasn’t happened, we don’t push ourselves to change. Montier observes that this happens even when a negligence is of life-threatening proportions. In a group of men and women who were educated on how a condom could prevent the spread of HIV/AIDS, a good percentage still chose not to use one. It’s their very life they’re risking but for some unfathomable reason, they’re supremely optimistic about their chances.

The traits Montier talks about through the book inflict people across the board. Especially over-optimism and excessive self-confidence. Now, I’m not an early riser. So when I set my alarm for 5.15am, I know there’s a good chance I won’t wake up. I even keep the alarm near me, so it’s easy to switch off without opening my eyes! Yet, over the last month, I did this every night, promising myself tomorrow would be different. Where did my optimism come from? I have no idea.

The only way I managed to break this record was keeping the alarm in the next room so I had to walk 20 feet to switch it off. By which time, I can usually usurp my inner devil and head to the washroom instead of the bed.

What I needed was an actionable step, not just a resolve.

Montier gives us actionable steps to alter our habits too. It’s not easy to change and unadvisable to try and change too much at a time. Our body and mind won’t take it.

So, start easy. Apply some rebiasing and simple rules.

To do this, follow a process. For investors, the investment plan provides the process. It is our strongest weapon against all behavioural pitfalls.

Remember, even the world’s leading investors are prone to weaknesses. That’s why they stay away from stock dashboards and media noise themselves, focusing only on their investment plan and giving the responsibility of execution to others.

So don’t be too hard on yourself. Even the best can go wrong without process. The important thing is to recognize and accept your weaknesses, and take steps to control them. Once you’ve figured that out, you’re on the road to becoming a better investor.

Let this be a new beginning.

Monica Samuel is doing a chapter-wise review of the book: The Little Book of Behavioral Investing: How not to be your worst enemy by James Montier. You can follow the series by following this tag: tlbbinvesting or by subscribing to this rss feed: tlbbifeed

Learning about traits that make us bad investors has been an enlightening but uncomfortable sojourn. Uncomfortable because too often, I’m guilty of the very behavior Montier discourages. A lifetime of bad habit is hard to correct! But the quality Montier explores in Chapter 15 of The Little Book of Behavioral Investing: How not to be your worst enemy will, I believe, prove the hardest of them all.

Have you heard the story of a speaker addressing a large crowd and saying “Half the people here are stupid.” Not surprisingly, the audience roars in resentment. He reframes, “Half the people here are intelligent.” The crowd is mollified though the implication of both statements is the same.

“Loss aversion,” the topic under discussion, has a similar psychological premise. Even professional golfers and capuchin monkeys suffer this weakness; not that they’re comparable but Montier gives us illustrative examples of both. Let me share the primate story with you.

An experiment was conducted where two testers played a game with capuchins:

Case 1: Give the monkey a grape. Flip a coin. On one outcome (heads or tails), give a bonus grape to the monkey.

Case 2: Give the monkey two grapes (bonus). Flip a coin. On one outcome, take one grape away from the monkey.

Case 1 is positioned as a gain and Case 2 as a loss. Even though both will lead to the monkey winning or at least retaining two grapes at a 50% probability, the capuchins returned predominately to the first experimenter. They exhibited loss aversion. And we’ve not evolved enough to get rid of this bias.

But it’s not just loss aversion that plays with our judgment. We are also blessed with a myopic point of view, making us too focused on the short-term. It’s why so many traders glue their eyes to online stock dashboards, watching stock prices every second. If you’re one of this group and still not a nervous wreck, hear this: You’ve got it wrong.

It’s unpractical to expect your portfolio stocks to do well in the short-term. Joel Greenblatt who advises investors to follow his magic formula recalls that “the magic formula portfolio fared poorly relative to the market average in five out of every 12 months tested. For full year periods the magic formula portfolio failed to beat the market average once every four years.” But it produced long-term gain.

You’d think loss aversion would have us cutting our losses wherever possible.  But that’s not the case. There’s a distinct difference in behavior “after loss” versus the “risk of incurring a loss”. People don’t believe a loss will materialize till it actually hits them. This is the disposition effect. It’s why investors stick with stocks they’d do better to sell.

The endowment effect – the tendency to overvalue something when we own it – makes it worse. A losing stock on my portfolio? There’s hope yet. A losing stock in the market? Stay away.

Here are some startling facts from Terry Odean’s examination of data from a discount brokerage:

• Investors held losing stocks for a median of 124 days versus 102 days for winning stocks.
• On average, individual investors sold 15% of all winning positions and only 9% of all losing positions.
• Winners sold outperformed losers that continued to be held by an average of 3.4% per annum.

This is loss aversion at work compounded by over-optimism, over-confidence and the self-attribution bias. And these stats hold good for both professional and individual investors.

The solution again is the resilient investment plan covered in Chapter 2. Stop losses alleviate the disposition effect in that selling or buying decisions are preempted by prior valuations rather than volatile data and reports. Of course, you must distinguish between cigar-butt stocks and compounders here. The former category includes stocks bought real cheap and sold when they’re near their intrinsic value. The latter is stocks that will gain intrinsic value over a longer period. These are the ones to stick with.

So, sometimes you take a call when new data comes up. But most times, you stick with your investment plan and sell at the right time.

Monica Samuel is doing a chapter-wise review of the book: The Little Book of Behavioral Investing: How not to be your worst enemy by James Montier. You can follow the series by following this tag: tlbbinvesting or by subscribing to this rss feed: tlbbifeed

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I didn’t know what a Lemming was. In case you don’t either, here’s what it is: “Any of various short-tailed furry-footed rodents of circumpolar distribution.” My next bright reaction was, “Huh?” Till I realized that what Warren Buffet’s referring to here is “pack behavior.” Montier describes it as the “willingness to subjugate one’s own thoughts for those of a group.”

And … you’ve guessed it right! This is exactly what Montier talks about in Chapter 14 of The Little Book of Behavioral Investing: How not to be your worst enemy.

As people, we tend to follow the herd. You’re not one of them? Really? When was the last time you made a contrary statement in a business meeting that your boss didn’t want to hear? And please, we’re all guilty of weird actions taken under the influence of peer pressure. The desire to be accepted, be part of a group … it’s a basic human need. And when we’re not careful, it leads to moral, ethical, and in this case, financial failure.

A number of experiments outlined by Montier prove that people who make smart accurate decisions when on their own miss the mark when made aware of a group judgment. They allow this information to influence their own sense of right and wrong, crushing their independent (and more accurate) thought. In one test, the accuracy rate of individuals’ answers fell from 90% to 59% once they saw other people’s results.

What’s even more interesting is the fear that’s triggered in our head on going against the crowd. Neuroscientists studied the brain scan of the experimental subjects during such tests. The found that:

• Going with a group answer decreases activity in the C-system, the part that handles logical thinking.
• Nonconformity triggers fear and pain. Non-inclusion or social ostracism activates the same brain parts activated by real physical pain.

Avoiding pain and fear can cost investors dearly. The proof of this lies in the fact that stocks sold by institutional fund managers actually outperform stocks they’re busy buying. Over a two year horizon, the difference is estimated to be as much as 17%. That’s a lot!

Group behavior has other ramifications, like the tentacles of an octopus. They protect their own, praising likeminded people and shunning those who refuse to buckle under the pressure. The “group think” behavior leads to faulty decisions based on:

• Over-optimism and over-confidence (of course, we can’t be wrong).
• Irrationality (blind collective rationalization).
• Rightful morality (loose sense of moral, ethical, logical or long-term consequences).
• Blanking out of dissenting views (don’t listen to the pessimists).
• Group pressure (arguments must not be aired).
• Blinders (no deviation from the perceived group consensus).
• Presumed unanimity (individual voices are drowned).
• Insulation of leaders (group cohesiveness priority over contradictory views).

So how do you beat this? By becoming a contrarian investor.

Warning: If you’re a professional investor with a yes-boss organization or even an educationist from academia, this view could get you out on your butt.

Now that we’re past that, here’s what you do:

First step: Admit you’re part of a herd. Curb the fundamental attribution bias. It makes us imagine we’re independent thinkers while the rest are easily influenced.

Breaking news! We’re all sheep!

Second step: Memorize the principles laid out by Ben Graham:

1. Have the courage to be different.
2. Be a critical thinker. To do this, you must understand why the market is not appreciating what you value as good stock.
3. Stick to your principles. If you believe your investment plan is based on sound valuations, don’t get distracted. Stick with it.

Be brave!

Monica Samuel is doing a chapter-wise review of the book: The Little Book of Behavioral Investing: How not to be your worst enemy by James Montier. You can follow the series by following this tag: tlbbinvesting or by subscribing to this rss feed: tlbbifeed