The Little Book of Behavioral Investing

February 11th, 2015

The Little Book of Behavioral Investing by James Montier front cover

Two main threads run through this Little Book. The first involves how a series of biases dictate how we as investors act in every stage of portfolio management. We are compelled to seek out information in support of our preconceived notions (confirmation bias), and to skew our interpretation of evidence so that it aligns more closely with how we already feel (biased assimilation). We also make up our minds early on and only grudgingly stray from our viewpoints once they're set (conservatism).

We believe that by quantifying our risk we are able to control it (value-at-risk). This illusion of control leads to over-optimism, which make us blind to bubbles in the market.

Meanwhile, we hold on to falling stocks in the anticipation that they'll recover, and sell rising stocks believing they'll fall (the disposition effect). This is partly due to how objects rise in subjective value the moment we acquire them, making them difficult for us to get rid of (the endowment effect). Author James Montier posits that we may also be willing to pay a higher price for stocks if we already own stocks in that company.

Furthermore, we have a habit of focusing on the short term (myopia), but constantly checking up on our portfolio makes us lose sight of the bigger picture and act rashly.

If things turn out well we attribute it to our own skills as investors (self-attribution bias), whereas we blame bad outcomes on external forces. And once we do know the outcome, we tend to believe we knew it all along (hindsight bias).

Obviously devising a sound investment plan and sticking to it goes a long way toward overcoming many of these biases. By considering during good times what to do in bad times, we are less likely to be overwhelmed once things inevitably get rough. Montier encourages keeping an investment diary detailing our thought process as we make investment decisions, as well as the results of those decisions.

The experts are subject to the same behavioral forces as you and I, and the relationship between individual investors on one side and professional money managers and experts on the other is the book's other major thread.

Montier comes down pretty hard on the prognosticators of the investment world for not basing their forecasts on proper analysis, but in my experience they often do take into account company fundamentals, sector research, broader socioeconomic influences etc. The issue is that they're still wrong a lot of the time. They can't know everything, and they can't predict the future.

Professional money managers are also prone to so-called groupthink. Among other things, this results in

  • an illusion of invulnerability that encourages taking extreme risks
  • an unchallenged belief that the views and decisions of the group are superior to those of other groups
  • group members being fearful of expressing views which run counter to those of the group as a whole, or being actively discouraged from doing so by the group. With this comes the contradiction that we think of ourselves as independent thinkers (introspection bias), yet we are subject to conformity; it's difficult to go against the market because being contrarian brings with it the social fear of being left out.

Procrastination poses one side of another contradiction. Even though we all have good intentions in the moment, once we actually have to do something with our good intentions, they fall through. This is in contrast to the action bias, an inherent need to act. Montier describes a study of soccer goalkeepers. During penalty kicks, the goalie will almost always jump either left or right, even though he'd have a statistically greater chance of catching the ball if he'd simply stay put. When queried, goalkeepers said that by jumping to either side they felt that they were at least making an active effort to catch the ball. In investing terms, the action bias means we can't leave our portfolio just sitting there. We believe that by doing something — anything — our investments will soar.

Montier stresses the importance of seeking out the right information as opposed to the most information. He touches upon the virtues of value investing and the importance of finding companies under good management, but I would have liked more concrete instructions of how to sift through the vast dung heap of information available at our fingertips to get to the good stuff.

Speaking of vast heaps, I have to mention the copious amounts of studies cited by Montier throughout. It feels like Montier collated a huge pile of studies, wrote conclusions to each, and wrote a book about it. I was almost amused when I read this:

A group of people were asked to read randomly selected studies on the deterrent efficacy of the death sentence (and criticisms of those studies).

In other words, a study of people reading studies about studies. I feel that too much space is dedicated to studies originating everywhere but in the investment world, and Montier often struggles to relate them to investing. This wouldn't be a problem if the book had been titled The Little Book of Human Behavior, but I was expecting a more focused approach. There's some pretty substantive padding at work here — disappointing in a book of this size — and the flow is broken by Montier's leapfrogging from one study to the next.