Tag: The Little Book of Behavioral Investing

Distinguishing the Signal from the Noise

As a writer, I have to read a lot. Sometimes I read up on a topic for hours because the internet is overflowing with information, opinions, expert advice and whatnot. I feel that if I don’t soak it all, I won’t do justice to the subject.  However even after hours travelling the Wikipedia wormhole, I found myself nowhere near a working article.

Thankfully, this is a story from my past. After many such wasteful episodes spread over months, I had the good sense to revise my strategy. Now when I research a topic, I think of 4-5 questions that the article must answer and limit my research to these areas. My research and writing is done in half the time I spent earlier and I feel that I have become a better writer because of it. In fact, now I get to spend more time on editing which is what pruning is to a rose bush.

And I am not alone in this. Study after study shows that we are incapable of telling the difference between more information and better information.

Montier talks about “information overload” in Chapter 6 of The Little Book of Behavioral Investing: How not to be your worst enemy. We are living in an age where excessive data is thrown at us from every angle – investment experts on multiple TV channels running round the clock, telling us we what we need to know, postmortem reports on failing stocks, and loads more. And not to mention the plethora of investment blogs on the internet that slice, dice and serve up the most arcane of data.

Montier’s advice: Close your eyes and ears to all the noise. He suggests that we first decide what attributes of a business would make it attractive to us. These factors can vary based on our investment goals and that’s ok. Montier himself, being a deep value investor, focuses on questions that are quite different from those asked by Warren Buffet. The goal is to stick to researching the business along these attributes only – thoroughly and deeply.

“More is not always preferable to less;” not unless you’re a computer. Montier illustrates the point with various examples of real life experiments. The premise: The accuracy of forecasts is evaluated based on lesser or more number of data variables provided to the decision maker. Irrespective of the test subjects – bookmakers, football fans, car purchasers or financial analysts – the observations are the same:

• The accuracy of predicted outcomes with 5 data variables is the same as with 40.
• The confidence of forecasters goes up as more data variables were handed out.

This means that though the confidence of forecasters goes up as more information is fed to them, they don’t end up making more accurate forecasts. You too may find that many of the financial “analysts” who ooze confidence on media only have a surface knowledge of what they’re talking about.

Montier uses another example to expound on what’s needed to improve the accuracy of forecasts. He refers to a hospital in Michigan where 90% of patients who came in with severe chest pains were inaccurately admitted to the ICU. This led to overcrowding, high costs, and deaths because of diseases contracted in the ICU. Researchers found that doctors were looking at the wrong factors during diagnosis. They corrected this problem by creating cards that doctors could reference for better decisions. The approach worked but that’s not really the moral of the story.

Researchers found that the doctor’s decision making prowess remained the same even when the cards were taken away. The doctors had over time assimilated the correct cues from the cards and started looking at the right factors during diagnosis. Their attention had moved from pseudodiagnostic to truly informative elements.

Researchers used this feedback to create simpler decision making assistants such as checklists. This helped to improve overall healthcare quality by ensuring process adherence across the board. As a result, patient death rate and post-op complications fell from 1.8% and 11% to 0.8% and 7%. Astonishing what a simple checklist helped to achieve!

Now we come to the moral of the story: You need to know what attributes to weigh to assess the soundness of your investment choice. Analyze on those lines only but analyze deep. Make a checklist, why not? Just make sure you don’t do that one thing – become directionless with second hand, surplus information.

Related:
The illusion of knowledge
The value of publicly available information is zero
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

Prepare – Don’t Predict!

On encountering a teacher from hell and believe me, they’ve been some, I would console myself with the quote “Those who can’t do, teach.” But 6th century poet and philosopher, Lao Tzu’s quote in Chapter 5 of The Little Book of Behavioral Investing: How not to be your worst enemy wins the deal for me: “Those who have knowledge don’t predict. Those who predict don’t have knowledge.”

It appears that Lao Tzu had a premonition of coming times when common man would be inundated with predictions from financial soothsayers and projectionists. He guessed right that we’d need some hard-core wisdom to pull ourselves away from the damaging influence.

Author James Montier ties the fatality of financial predictions to the over-confidence of economists and investment experts. If you remember, we discussed this aspect of investors in Chapter 4, along with a depressing succession of human flaws outlined in earlier chapters – procrastination, temporary paralysis, illusional control, and the empathy gap. Mercifully, Montier also provides a practicable solution that can save us.

But coming back to the folly of believing in forecasts: Did you know that the consensus of economists failed to predict any of the last four recessions, including the 2008 crash? In fact, the track record of economist predictions is abysmal in both short and long-term issues. Stocks that analysts profess will go up at an accelerated pace over a 5 year trajectory have tended to move at a snail’s tempo.

But why only forecasting, analysts also try setting the target price of securities even after overwhelming evidence of their colossal failure in this regard. For example, in 2000, target prices were 37% above the market price. Analysts predicted that the stocks would go up 24% in 2008. Instead they fell, that too by 40%. It reminds me of the time we bought our house in 2008. After waiting for years for property rates to stabilize or fall (hey, optimism is a default trait), we finally invested. And the very next month, prices fell.

As Keynes says, “We simply do not know.” And that is literally the only thing we know for sure about the future.

The failure of economists and analysts are well documented. Economic forecasters even missed recessions when they were already underway. And it is not just economists who are consistently wrong. Experts of all “soft” sciences are overconfident about their own predictive prowess. For instance, Nate Silver points out that if political scientists couldn’t predict the downfall of the Soviet Union – perhaps the most important event in the latter half of the twentieth century – then what exactly were they good for?

So now we know that economists are bad forecasters. Worse, unlike weathermen, they don’t even own up to it. So why is it that financial predictions are featured everywhere?

It’s a simple case of demand and supply. People want it, media provides it. Add to that our own indolence in going with “ready-to-eat” rather than cooking from scratch. Investors want actionable information to justify their buy or sell decisions so economists provide it in bulk. It’s easier for us to have them do our homework. The only problem with this approach is that when predictions fall flat, the economist slinks away mouthing a disclaimer while we are stuck with a red face, a loss or worse, a debt.

Don’t put yourself in this situation.

Montier points out another evil of forecasts – a trait called anchoring. Research shows that if given a number, we tend to stick with it. In an experiment, when people wrote a number, it stuck in their mind such that when asked to write another random number later, they didn’t go too far from the first. This happened even when participants were aware that the first and second numbers were isolated entities with no relation to each other.

This means that even if we read a forecast and don’t believe it, our mind subconsciously deviates to it in our mental processes. Solution? Stay clear of forecasts altogether.

But what then should we base our investment decisions on? Montier says – nothing but penetrating research and analysis. Instead of imagining future value, evaluate the current value of a business, its nature and intrinsic worth. He suggests a backtracking methodology: Take the current price and go back to assess growth. Compare the growth rate with that of other firms in the same timeframe. If the company is already at the limits of the growth patterns, reconsider your buy decision.

An alternative approach is offered by Bruce Greenwald at Columbia University but Montier’s sympathies lie with Howard Marks of Oaktree Capital who says: “You can’t predict, you can prepare.” Meaning that you need to know where you are even if you don’t know where you are going for sure. And to be sure of where you are, you need to do your homework yourself.

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

Stop Listening to the Experts!

“Too much of anything can destroy you.” Famous words from the City of Lost Souls. And how true they are! James Montier, author of The Little Book of Behavioral Investing: How not to be your worst enemy, doles out more cheer for us in Chapter 4. This time he uses unequivocal research data to turn the spotlight on another human vulnerability that makes us shoddy investors. It’s “over-confidence.”

The key lesson from this chapter wasn’t a very happy one for me. In fact, it was depressingly accurate, as proven by history. Let me explain.

Research proves that people (and I include myself here) often take dimwitted, brash, even inhumane actions if it conforms to an authority figure’s opinion or instruction. So tremendous is the influence of authority that it completely overrides our capacity to self-judge and cogitate.

Montier gives a chilling example: In the 1960s, Stanley Milgram conducted experiments to understand why ordinary people executed the detestable policies of leaders in World War II. A scenario was recreated where a “teacher” in authoritative attire instructed a “student” to press switches that increasingly raised the voltage level of shocks applied to “learners.” Voltage levels were clearly marked on the switches with descriptions ranging from “Slight” to “Danger: Severe Shock” to “XXX.” The students were told that that the aim of the experiment was to study the effect of punishment on learning and memory.

One would think that no student would have gone beyond the “Extreme Intensity Shock” level, especially since shock deliveries were accompanied by auditory reactions of the student that ranged from grunts to agonized screams. But what do you think happened?

Shockingly, 100% of the “ordinary people” willingly went up to 135V either themselves or by instructing another person, a stranger to them. This level was beyond the point where the learner asks to be released. Almost 80% were ready to go up to 280V where they could hear screams and 62% were willing to go up to XXX.

Such is the dangerous, brain-debilitating influence of authority.

And what is authority really? Usually, nothing more than over-confidence delivered with aplomb. Doctors do it all the time as do politicians and investment experts on Dalal Street. They get away with making fools of us because we get taken in by authority.

Montier warns us to be skeptical of experts, especially if they are fund managers. Take the example of Joe Granville, legendary market-timer and technical analyst. He started off well and gained credibility but the consistency of his predictions soon wore off. While his skill fumbled, his confidence did not. As long as he kept up his showmanship and appeared confident of his outlook, he was never short of gullible believers.

Montier outlines another experiment. Students and fund managers were pitted against each other to test stock-picking skills. Each team was handed research data on each blue-chip stock – name, industry, and prior 12 months’ performance. The students claimed 59% confidence in their skills and the professionals 65%. Not surprisingly, the students performed sub-optimally at less than 50%, relying on guessing games. But fire and brimstone! The professionals picked the right stock less than 40% of the times!

This happened because of the professionals’ over-confident reliance on “other knowledge” apart from what was handed to them. These are the very people who feature across media, glibly advising us on our investment strategies. Why, we’d be better off playing tic-tac-toe ourselves!

So we’re back to the game plan. Beat this hurdle by sticking to your investment plan, disregarding expert drones, and ignoring what others are doing.

But I can’t end this review without an interesting mention (it’s too irresistible): Turns out that men are more prone to over-optimism and over-confidence. They are not only worse investors than women but also a bad influence during investment decision-making. Don’t believe me? All hail to Montier and his penchant for research results! Zoom in to Chapter 4.

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

“But, Why Should I Own This Investment?”

Hope keeps the world going. Optimism makes awful situations bearable. Both are laudable qualities; invaluable life skills that help us survive. But in the investment world, hope can take you from prosperity to penury in no time. In the investment jungle, it’s the pessimists and skeptics who win.

So, we’re on to Chapter 3 of The Little Book of Behavioral Investing: How not to be your worst enemy, and back to recounting the many weaknesses of the home sapiens family that make us bad investors. First, we learned about the “empathy gap,” then “temporary paralysis,” and this time it’s our inescapable preponderance towards optimism, compounded by the illusion of control.

According to motivational speakers and life experts, those who see the glass half-full have a better chance at happiness than those who see it half-empty. Maybe so. But this viewpoint can also lead to a false sense of security that can backfire in trading. Montier elucidates the point.

According to him, too many of us have an inflated opinion of our own abilities, acumen or intellect. Though that’s not a very nice thing for him to say, there’s some truth in it. I believe that if I ever fall down the balcony of my third floor apartment (yes, weird thoughts come and go in my head) onto the soft green garden below, I’ll land on all fours like an agile cat. My brain knows it’s improbable but I somehow believe that’s how it will be.

Optimism (however foolish) is a hard thing to get rid of unless you’re clinically depressed. In fact, depression is probably a good mental state while devising an investment strategy but that’s easier said than done. Optimism is a default reaction, too deeply ingrained in our X-systems (another thing to blame on evolution) to shake off. Research further shows that we become even more optimistic under pressure, a dangerous frame of mind for investors.

Stockbroker research too is largely optimistic. In fact, highly publicized ratings and market research available on Dalal Street listings, media channels and expert talk shows are often a mix of optimism, borrowed research, questionable valuation methodologies, self-serving bias, and sensationalism. Montier outlines 3 self-serving principles of stockbroker research:

Rule 1: All news is good news.

Rule 2: Everything is always cheap.

Rule 3: Assertion trumps evidence.

If only optimism could be switched on or off per convenience. Many of the top investors manage it. But it’s not going to be easy, bet on it. Good practices never are.

Montier believes we’re all victims of the illusion of control too. We think we know what we’re doing after experiencing a run of good luck in say, a game of cards, a lottery or trading. We start believing that we have the Midas touch; that a series of coincidences is really an outcome of our skill. Wrongly placed confidence leads to flawed decision making which leads to loss and pessimism. And what good will that do you now?

So, how do we beat over-optimism? A simple way is to change our default trading question from “Why shouldn’t I own this stock?” to “Why should I own this stock?” Become skeptical of every piece of research that comes in; evaluate it by your own standards. Suspect, question, and learn to say “no,” not only to others but also yourself. And make sure that it fits into a larger investment theme.

If this turns you into a complete cynic, so be it. At least you’ll have some profit to smirk on. Or for all you know, you’ll manage the Dr. Jekyll and Hyde business easily. See? Optimism! Nothing kills it.

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