The Little Book of Behavioural Investing: Book Notes

This post has my personal notes from the book, The Little Book of Behavioural Investing by James Montier.

The investor’s chief problem – and even his worst enemy – is likely to be himself. -Benjamin Graham

1. We think that behavioural biases and mistakes that behavioural psychology talks about applies to others and not to ourselves. This is the bias blind spot we all have. There are two approaches to decision-making: emotional and logical. The emotion way is the quick and dirty way, using short-cuts and based on similarity, familiarity and proximity(in time) and helps us deal with large amounts of information in a short time and gives us approximate answers. The logical way slow and serial way of dealing with information and uses a deductive approach to arrive at precise answers. Investing is an area where you have complex problems, incomplete information, ill defined goals, high stress and interaction with others. We need to control our emotion if we have to be successful. That is why Warren Buffet said: Success in investing doesn’t correlate with IQ once you’re above the level of 100. But will-power alone is not sufficient. Investing is simple-but not easy, as the great master says. We have behave better while investing and we shall see how to do it.

2. Empathy gap means this: The inability to predict our own future behaviour under emotional strain. When asked in the cold light of the day how we will behave in the future, we turn out very bad at imagining how we will act in the heat of the moment. Procrastination means this: The dreadful urge you suffer, when you know there is work to be done, to put it off as long as possible. To prevent this we have to use the method of pre-commitment. Perfect planning and preparation prevent piss poor performance. This means we have to do our research in a rational manner and when nothing much is happening in the markets. Then we have to to pre-commit to following our own analysis and prepared action steps. Only by doing so we can follow Templeton’s maxim: The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell. An example of doing this is to fix your buy prices well ahead. When the market goes into a panic and prices fall to the level you have fixed, you buy.

3. Fear causes people to avoid bargains when they are available in the market, especially if they have previously suffered a loss. People who invest using their emotional mind are especially affected by it while people who invest using their rational mind are less affected by it. If we want to be successful in investing, we have to invest when the stock price is falling and there is market panic. We should not get stressed at that moment. To do this, you have to have some money in cash or bonds as dry powder to invest when the market goes down. We have to do things which Seth Klarman advises: willingness to hold cash in the absence of compelling investment opportunity, a strong sell discipline, significant hedging activity and avoidance of recourse leverage, among others.

4. Optimism is ingrained in the human psyche. We have a tendency to overrate our abilities. We think have control over outcomes and often mistake randomness for control. This happens commonly in investing. Optimism is a great life strategy. But it is not a great investment strategy. It is what makes us invest in low quality securities at times of favourable business conditions. The person who sells an investment to you is also very optimistic generally. Investment seller research often shows these three self-serving principles:

  • All news is good news( if the news is bad, it can always get better)
  • Everything is always cheap( even if you have to make up new valuation methodologies)
  • Assertion trumps evidence( never let the facts get in the way of a good story)

To prevent over optimism we should ask:

  • Must I believe this? rather than Can I believe this?
  • Why should I own this investment? rather than Why shouldn’t I own this investment?

5. We are generally overconfident in our abilities. Experts are generally even more overconfident than the rest of us. We love people to sound confident, even if they may be inaccurate. We also tend to blindly follow authority. But these things are hazardous to making money. It has been proven that trading too often because of overconfidence results in poorer returns and it is unlikely any of us can outsmart everyone else- get in before everyone else and get out before the herd dashes for the exit. The good news is that we do not 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.

6. Most of the investment industry seems to be obsessed with trying to guess the future. It is impossible to be certain what the future will bring. But we still like somebody to tell what will happen to the price of an investment. And we use these forecasts to determine the value of something based on a forecasted number. We want an anchor.  What we need to do instead is to understand the nature of the business and its intrinsic worth, do reverse discounted cash flow than discounted cash flow and see what the world expects and whether it is possible. You can also compare earnings power value to asset value. You can also try to find out where you are in relation to cycles that have occurred in the past. It is better to be approximately right than being precisely wrong. Investing without pretending you know the future gives you a very different perspective and you do not need to forecast to be successful at investing.

7. We seem addicted to information. But most information is noise. We humans have limits on our ability to process information. We do need information but they need to be good information, something you can put in a simple checklist. It is far better to focus on what really matters rather than succumbing to the noise that goes on daily in the investing world. You need to focus on four or five things you really need to know about an investment, rather than trying to know absolutely everything about everything concerned with the investment.

8. Most of the price fluctuations that happen every day are random. Yet we cling on to them because they are our only foothold in the uncertain world of investing. This is Mr. Market-the chronic manic depressive.Get away from him and you will invest better.

9. We look for evidence that agrees with our way of thinking. This is called confirmatory bias. But what we should do is to 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. We also tend to see all information as supporting our hypothesis and we distort the information to suit our existing preference. We need to look for evidence that would prove our own analysis wrong. If we can’t find any we may be onto something.

10. We hang on to our views too long. This is because we have spent time and effort in coming up with those views in the first place. We have to periodically look at our investments and start afresh as to whether we will invest more or not. If we will not, then we might be better off selling. Or we should spend time criticising what we have invested in. Or rarely, we should sell everything and start off with a clean slate and invest again.

11. Stories govern the way we think. We will abandon evidence in favour of a good story. We shun value stocks because of their poor stories and low prices. We admire growth stocks because of their good stories and high prices. We should do the opposite and we don’t. We also like IPOs- those that have great stories attached to them. But this will lead to a lot of investment losses. We must focus on facts- assets, earnings, dividends and definite prospects rather than stories.

12. A bubble is defined as a real price movement that is at least two standard deviations from the trend. A bubble is usually not a black swan. It is a predictable surprise. But five major psychological hurdles prevent us from seeing these bubbles:

  • Overoptimism: The tendency to look on the brighter side helps to blind us to the dangers posed by predictable surprises.
  • Illusion of control: The belief that we can influence the outcome of uncontrollable events.
  • Self-serving bias: The innate desire to interpret information and act in ways that are supportive of our own self-interests
  • Myopia: An overt focus on the short-term.
  • Inattentional blindness: We simply don’t expect to see what we are not looking for.

To spot these bubbles we should remember:

  • If something can’t go on forever, it won’t. If markets seem too good to be true, they probably are.
  • We need to have an adequate idea of stock market history, in terms particularly of the major fluctuations.
  • Understand the five stages of the bubble. Displacement-credit creation-euphoria-critical stage/financial distress-revulsion.

The advantage as an individual investor is that you do not have to be a slave to an arbitrary benchmark. We should avoid leverage. We should remember that the odds of failure may be low, but if it happens, you will lose everything. We should not invest in such things.

13. We do not learn from our mistakes. We have an unwillingness to recognize our mistakes and errors as such. This is because to two things. One is self-attribution bias. We attribute good outcomes to our skill as investors while blaming bad outcomes on something or somebody else. To avoid this- we need to keep an investment diary- a written record of the decisions we take and the reasons behind those decisions. Then we need to look at our outcomes and our reasonings:

  • Good outcome+right reasoning=Skill(perhaps)
  • Good outcome+bad reasoning =Good Luck
  • Bad outcome+good reasoning=Bad Luck
  • Bad outcome+wrong reasoning=Mistake

The other reason is because of hind sight bias. This simply refers to the idea that once we know the outcome we tend to think we knew it all the time. This can again be overcome by an investment diary. An investment diary can be of real benefit to investors because it helps to hold us true to our thoughts at the actual point in time, rather than our reassessed version of events after we know the outcomes. An investment diary is a simple but very effective method of learning from mistakes, and should form a central part of your approach to investment.

14. We have myopia when it comes to investing. We have an overt focus on the short-term. At a one year horizon the majority of your total return comes from changes in valuation- which are effectively random fluctuations in price. At a five-year horizon, 80% of your total return depends on the price you pay plus the growth in the underlying cashflow. Therefore as long-term investors you need to hold the stock for a long period. Not only do we want quick results, but we love to do something, as opposed to doing nothing. This is called action bias. This action bias intensifies after a loss- a period of poor performance. We have to have patience and discipline when nothing of value turns up. Then, when something of value turns up, we should buy and hold on to it for a long period. This will lead to success.

15. We do not keep up our independence in the face of pressure. Nonconformity triggers fear. Going against the crowd makes us scared. and causes social pain. But that is what is needed to be successful in investing. But we often engage in group think and that often leads to mediocre results. To be a contrarian and be successful at it, you need three things:

  • The courage to be different
  • The ability to think critically.
  • The perseverance and grit to stick to your principles.

16. We also have loss aversion. In investing, there is bound to be a lot of short-term losses. If we are myopic and focus too much on short-term losses then we will not be able to win in the long run. We therefore hold on to losing positions( inaction bias) and sell winners too soon. We sometimes sell losers while we should be buying more of them. Having stop losses may make sense sometimes. especially when you are investing based on momentum. Once you own something you place a higher value on it. This is called the endowment effect and that is another reason we do not sell. When we have a loss, sometimes we should sell, sometimes we should do nothing and sometimes we should buy more. That is difficult and it is.

17. We have to focus on process and not on outcomes. Process is within our control. Outcomes are not. Focusing upon process frees us up from worrying about aspects of investment we cannot really control-such as return. By focusing on process we maximise our potential to generate good long-term returns. But often this can lead to poor short-term returns. But if your process is sound, you should stick to it and do not be led astray.

18. Knowledge does not equal behaviour. To change behaviour we have to start simple. Change one thing at a time. Start small. The main thing is to concentrate on process-the set of rules that govern how we go about investing.

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