Tag: The Little Book of Behavioral Investing

The Little Book of Behavioral Investing: The Big Bad Market

“Who’s Afraid of the Big Bad Market?”

I’ve always been afraid of heights. When I heard that a team building session at my last workplace would include a rappelling event, I was scared witless. But I wanted to face my fears and went for it. One look down that 50 foot cliff … and my bravado melted like wax. Sure, I went ahead (in a suicidal kind of mindset) and ended up winning the Comedy Award. I let go of the rope (not supposed to do that) and plastered myself on the cliff wall like a lizard, not going up or down, much to the glee of my supportive teammates.

Next year, we had the session again. And this time I prepared. I had a game plan: “Do not let go of the rope EVER!” After repeating that in my head for about the millionth time, I went ahead and believe it or not, actually made it, if not in the most graceful manner, at least without acute embarrassment.

Cover of "The Little Book of Behavioral I...

When I read Chapter 2 of the The Little Book of Behavioral Investing: How not to be your worst enemy, I felt quite proud of myself. After all, I too made a game plan to overcome fear and stuck to it. That’s what the best investors in the world have always done. Stuck to their investment plan, no matter what.

If you remember, author James Montier talked about “empathy gap” and “procrastination” in Chapter 1 – two human frailties that make us bad investors. But the list doesn’t end there. How could it? Turns out we are also susceptible to a strange malady called “temporary paralysis.” Though it’s not a neural disorder in medical terms, it produces similar reactions of helplessness and frustration in investors.

The well-researched causes of temporary paralysis have been found to be “fear” and “brain drain.” To explain, let me (very shortly) give you a gist of various experimental observations recorded by Montier. The first experiment involved a game where higher risks would yield higher returns.

  • A group that functions without fear (a state reached after suffering specific brain damage, not caused by a lightning bolt from an alien ship) invests often irrespective of earlier wins or losses. Their profits are optimal.
  • People with brain damage but whose X-system is unaffected (hence, can experience fear) invest fewer times and earn lower profits.
  • The diffident “normal” group performs the worst. They invest cautiously at all times which drops to less than 40% after suffering a loss. Profits are lowest, well below average.
  • As the game proceeds, the decision-making ability of the latter groups only gets worse.

In another experiment involving the Stroop Test, it was found that people with stronger C-systems perform optimally every time. Those with stronger X-systems managed for a while but performance fell steadily thereon. This is “brain drain,” the inability to sustain will power and self-control over an extended period.

So what do these experiments tell us? Fear leads to sub-optimal behavior that only gets worse with time. Montier compares this to how people behave in bear markets. Instead of picking up unbelievable bargains, they hold on to cash out of fear, waiting for the rise from the bottom. They lose the early mover advantage.

Montier’s solution for temporary paralysis is the same “Prepare, plan and pre-commit to a strategy.” Have a battle plan for reinvestment to profit from a tumbling market.

Jeremy Grantham, chief strategist of GMO, suggests investing large sums in a distributed and pre-defined manner instead of taking one giant leap. Seth Klarman, head of Baupost and exemplary value investor advises us to put money to work before it hits bottom. He also warns that things will get worse before they get better. Be ready for it.

Most successful investors, in fact, delink the process of research from buy/sell decisions. Great companies may not always make great stocks and vice versa. The key is to make investment research a continuous process and keep a ready “white-list” of investments that are then traded based on pre-set buy and sell rules.

Bottom line: Plan, pre-commit, and execute. Stay disciplined and block every other thought.

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

The Little Book of Behavioral Investing: The Empathy Gap

“Prepare, plan and pre-commit to a strategy”

However astute an investor believes himself to be, he is weakened by the “empathy gap,” a human being’s inherent inability to predict his own behavior in the heat of the moment. It’s easy to take logical decisions when everything’s going our way but under pressure, the best of us can crack, in terribly embarrassing ways at times.

In the first chapter of The Little Book of Behavioral Investing: How not to be your worst enemy, James Montier elucidates on the human traits that condemn us to self-punishing propensities. First, we suffer from the empathy gap. And if that’s not enough, we also bear the brunt of procrastination – that frustrating but inevitable habit of pushing things to the last moment.

Cover of "The Little Book of Behavioral I...

Life, in general, is very forgiving of these foibles. However, the market is a heartless beast. Markets do not care about you, your family or your feelings. If you truly want to become a better investor there’s no way around it; you’ve got to deal with procrastination and empathy gap. Montier suggests a strategy: Prepare and pre-commit. Let’s see what this means.

Pay special attention to planning and preparation techniques while devising your investment strategy. For starters, conduct your research when the market is neither here nor there and the chances of your getting upset or excited are minimal. A cold, rational state of mind is ideal for unemotional observations, drawing logical conclusions and analyzing situations and markets. It’s the perfect time to chalk out an action plan that covers your best and worst “what-if” scenarios.

When you think about it, the worst place to look for research is CNBC and financial media in general. The ad-based business model of media companies motivates them towards the sensational. It’s better for them to focus on Who, What, Where, When, Why, and How rather than the boring and mundane process of actually reading a prospectus or balance-sheet.

Now, why should you prepare and pre-commit? To stop you from taking an original decision in the throes of a volatile market scenario. The trading floor is not the place to follow your instinct. Instead, follow the pre-decided action plan and blindly follow instructions. That’s how you prevent transient emotion or group behavior from influencing your buy or sell decisions.

Now, like a lot of things we read, this may sound easy. But it’s anything but, believe me.

A bad investment choice is like falling for a guy everyone warns you about because your heart thinks your brain is a pessimist. When you’re blindly in love, you can’t imagine it otherwise. And when you’re deep in the dumps, it’s hard to imagine being happy again. Pre-committing to an investment plan may trigger similar reactions. Your C and X systems may lock in constant battle while nightmares of horrific “what-if” situations may mess with your blood pressure. But stick to it. Training your C system will take time and perseverance.

If you need motivation, history is replete with examples of bad investment choices. The dot-com bubble brought umpteen businesses and investors to the point of bankruptcy and pushed many into oblivion. Greed, shortsightedness, and hurried decisions cost investors heavily.

And then there are people like Sir John Templeton, legendary investor and mutual fund pioneer. He made his buy decisions well in advance of sell off periods, giving standing instructions for his brokers to execute under pre-imagined situations. He kept himself out of the buying/selling process.

If a man as seasoned as Sir John didn’t trust himself to take the right decision under stress, I’m sure we can’t afford the confidence. So set your emotions aside and pre-commit to a thoroughly planned investment strategy.

One way StockViz helps you pre-commit to a strategy is through Investment Themes. Each Theme follows a specific model for portfolio construction and can be mapped to your portfolio so that changes in the Theme get reflected on your account. Call us to find out how it works: +91 80 2665 0232 or email us at info@stockviz.biz

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

The Little Book of Behavioral Investing: Introduction

Now here’s a book that really is about you, just as it claims. It’s a rare treat among the seriously brain freezing literature available on investment, all extremely knowledgeable I’m sure but dreadfully painful to read. “The Little Book of Behavioral Investing: How not to be your worst enemy” by James Montier grabs you from the very start because: (a) the author’s style is beguiling and amusing, (b) through the subtle humor, you get the message in all its clarity, (c) it’s extremely relatable. Many of the behavioral streaks mentioned in the book will resonate with readers, from the worst investor to the best. And even the best become their worst enemy at times, says Montier.

In the book’s introduction, Montier mentions a startling fact. According to the annual Dalbar studies, the S&P 500 has generated just over 8 percent on average each year, over the last 20 years. So perhaps individual equity investors can be tagged at 6 to 7 percent, yes? Wrong. Equity fund investors actually earn a paltry 1.9 percent per annum, primarily because of selling and buying at the worst possible times.

Cover of "The Little Book of Behavioral I...

In his book, Montier discusses the human traits that make us take illogical and potentially expensive decisions. Thankfully, he also offers solutions to these challenges, most of which are fairly easy to practice, with some discipline. Through the book, Montier shares experiences of leading investors across the world. Like us, they too have succumbed to mental pitfalls at some time. It’s heartening to know, isn’t it? Montier hopes this book will make each of us look inwards, at our own human biases.

To our credit, it’s not really our fault. We can blame it all on evolution. Montier believes we’re still wired to fit into a world that existed 150,000 years ago. Our brains haven’t kept up with the change in our circumstances. Therefore, till we invent technology that brings our brains up to speed, you need this book.

Montier also makes an interesting analogy of our human biases with Star Trek’s Spock, logician and emotionally unsusceptible (but even he got confused at times) and McCoy, the ever emotional comrade. Our brain too has an X-system that aims to satisfy and please quickly, often drawing a picture based on our wishes rather than reality; and a C-system that’s driven by logic. It’s slower in drawing conclusions and as luck would have it, is harder to engage. Additionally, the X-system evolved before the C-system which explains why we are all driven by emotion. If you think you’re a Spock, get the book and get on with the CRT test. Tell me how it goes.

Cultivating our C-system takes perseverance, constant practice and time. It can also be mentally exhausting. Again, Montier has a solution. Now, it may be over-optimistic to believe that each of us will rise to John Templeton levels by the end of this book, but if it doesn’t make you rethink your investment strategies, well, I’ll eat my hat!

(PS: I live in India. I don’t wear a hat.)


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