Book Summary: - “The Little Book of Behavioural Investing”
15th December 2021
Book Summary: - “The Little Book of Behavioural Investing”
Dear Fellow Investors,
We are sharing very serious stuff on investing today. If you think you
are a serious investor – then this is a must-read for you. For a time-pass
investor – this will be too heavy. So, avoid this post. This book is the master
book to think about investing psychology. Investing is 95% psychology and 5% all other
stuff. All our blogs are focused on 95%.
Do you KNOW?
• How you can be your worst enemy
when it comes
to investing?
• What are the various
human biases that
trip you when
investing?
• What is the best investment strategy?
• How to spot a bubble (and
avoid it)?
In The Little Book of Behavioural Investing, expert James Montier takes you through some of the most important behavioural challenges faced by investors. Montier
reveals that the most common
psychological barriers, clearly showing how emotion,
overconfidence, and a multitude of other behavioural traits, can affect investment
decision–making.
Bias, emotion, and overconfidence are just three
of the many behavioural traits that can lead investors to lose money or achieve lower returns. Behavioural finance,
which recognizes that there is a psychological element to all investor decision–making, can help you overcome this
obstacle.
There's no winter
coming…
Humans are inherently optimistic. We hold an extremely high
belief in ourselves- as students or as professionals, and as investors. An illusion of control further
complicates this elevated sense of self.
It has been
found that people
are willing to pay four
times the price
of a lottery ticket
when given the
flexibility of choosing the
numbers in the ticket. From a mathematical probability perspective, nothing
much has changed. However, the illusion of control provided
by 'selecting the numbers' makes the lottery
ticket buyer think that he
has a higher chance of winning because
he (or she)
can personally select
the numbers in the ticket.
(The
above example is valid for your marriage/career and anything and everything you
choose from a MATHEMATICAL PERSPECTIVE and not an emotional perspective).
Quiz
Time
Let's begin with
a quiz question: 'A bat and a ball
together cost $1.10
in total. The bat costs
a dollar more than the ball. How much does the ball cost?’
What
is your answer?
Did you answer $0.10? Or did you figure out the correct
answer, which is $0.05?
This question is one of the three questions asked in the
Cognitive Reflection test,
which is considered more difficult than
most IQ or SAT tests.
Why do we jump
to conclusions, when
spending a few seconds
thinking through would
lead us to the correct
answer?
This
has got to do with how our
brain thinks. This is the X system of
information processing that the brain indulges in. X system is the brain's
default mode of operation. The X system comes into play automatically and without much effort and is often behind
our emotional responses.
If you took some time and answered the bat and ball question as
$0.05, you held back your default X thinking system
and got the C system to work for you. The C system of the brain is
the logical system. It requires more
deliberate effort to get the C system to work for you. In trying
to think logically, the C system gets slowed down and
therefore is slower
as compared to the default
X system.
Is optimism a good
investment strategy?
Our high sense of self-esteem and optimism is the X system at work.
The X system of thinking dates back to our
ancestors when life was more difficult in terms of risk to life. Optimism
was a survival strategy for our ancestors.
However, optimism is not a good strategy for modern-day investors.
In fact, over-optimism is a bane
for investors. Being skeptical and questioning optimistic scenarios is possibly the best investment strategy. Indeed, the best investors ask themselves 'Why should I own this
stock?' rather than 'Why shouldn't I own this stock?'
Procrastination
& the investor
The empathy gap is defined
as the inability to predict
our behaviour in the future,
when we may be under
emotional stress. The familiar
feeling that you will never eat so much again,
after an unusually
heavy meal, is an example
of an empathy gap. Having overeaten
then, you feel that you will never overeat again in the future. A resolve that gets broken the next time you are starving, and
there is a delicious spread
laid out for you.
Procrastination is the most significant reason
for empathy gaps. When the deadline is far away, you are unable to
predict how you will do your project
at the last moment. Moreover, that is precisely what most of us end up
doing-finishing our work
under extreme stress
at the last
minute, thereby turning
in suboptimal quality
work.
In the world of investments, this
translates into making errors in investment decisions, which can then lead to
massive losses for you and your customers.
The solution to this lies in what is known as pre-commitment. For investors, this
translates into two steps:
• Plan your
investment when you are not
agitated or when
the markets are not volatile
• Pre-commit yourself
to the action points devised
using the planning
step above
As Sir John Templeton said 'The
time of maximum pessimism is the best time to buy, and the time of maximum
optimism is the best time to sell'.
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People
hold on to their cash while those over-invested
in the market freeze. The only
way to overcome terminal paralysis is to stick
to your pre-committed plan that you devised when things were 'normal'.
Trust
me, I am an expert!
Like optimism, investors should
be aware of experts. Humans tend to confuse confidence with skill. The general belief is that if someone is
extremely confident, he or she must be good! Moreover,
it has been proven in psychology studies that
experts are more
overconfident than the rest of us.
In a group of weathermen and doctors, the weathermen turned
out to be more confident
of their predictions- when the weathermen predict
they will be right 50% of the time, they were. However, doctors in such studies predicted that they would
be right 90% of the time, only to find that they were right just 15% of the time. This disparity happens because we prefer doctors
who are confident, thereby egging doctors
to be more confident than they
are. Will we go to a doctor
who is not sure of his diagnosis? Probably not.
I
predict a five-fold return on your money
So, are fund managers weathermen or doctors? Unfortunately, it turns out that fund managers leave doctors far behind when it comes to demonstrating
overconfidence in their predictions. Indeed,
the illusion of being an 'expert' drives their
overconfidence, which others
confuse with skill,
thus believing in experts. This gets further
complicated when you add the 'ability to forecast' to the 'expertise' of these experts.
It is safe to assume with a
certain level of confidence that
forecasting is more
about overconfidence than
a genuine skill
set.
(those who are relying on fund managers – must read above).
Predicting the future
in the world of investment is 'sheer madness.' If forecasting is of no practical use,
then why do we keep doing forecasts? In one of the most exhaustive studies
done on forecasting, Philip Tetlock
found that across a wide range
of forecasts, the experts were
marginally better than someone who can make forecasts using just the toss of a coin. In
such a scenario, why should we depend on forecasting?
Moreover, by the way, isn't
Discounted Cash Flow (DCF) a forecasting method?
Is
DCF a wrong analysis tool then?
The answer is that there
are better methods
than DCF. The reverse-engineered DCF where instead
of forecasting the future,
you take the current market price and
understand what it implies for future
growth, is a better method. Another alternative is the Greenwald Approach that compares
asset value to earnings power
value and then builds
a view of the intrinsic value.
The third option to standard DCF is what Howard Marks of Oaktree
Capital believes in-instead of predicting
cycles, prepare for them, not
in the context of predicting
(or forecasting) the
cycle but understanding your present
position in the context
of the cycle, i.e. knowing
where you are in the cycle.
(the most normal investors fail
to understand the simple logic of Howard Marks).
Our
analysis captures million data points!
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Studies have shown that
decisions are taken faster and more accurately when a lesser amount
of information is available.
Having more information just increases the confidence of the decision-maker and confidence, as we saw earlier,
can often be mistaken
for skills.
As investors, it is essential to separate the signal from
the noise. The leading
expert in separating signal from noise is Warren Buffet. Buffet does not look into in-depth data analysis of the next quarter's projections. Instead, he looks for underlying economic and financial
fundamentals when evaluating an investment decision. (Marco scenario is more
important than the Microdata you may have in short term).
In all likelihood, the valuation of a stock, its balance sheet,
and the discipline of the board
managing the cash
on behalf of the stock are good enough
for most investment decisions. You might not feel confident
making decisions with just these three parameters, but that is what information overload does to you- it makes you feel confident when you should not be. TV
analysts thrive on confidence perpetuated by an information overload. Not peeking into the
TV screen or your Bloomberg terminal may be a wise
investment decision.
Surprise
me because I hate shocks
Confirmation bias is another enemy of making rational investment
decisions. Confirmation bias is about selectively looking for information that
supports our views or beliefs. Excellent fund managers or investment analysts
will consciously look for evidence or information that proves their analysis
wrong. Remember 'Why should I buy this
stock' vs 'Why shouldn't I buy this stock?’
Bruce
Berkowitz of Fairholme Capital
Management says he 'tries to kill
the company' when he evaluates it for investment. Instead
of looking for information that supports the investment decision, Berkowitz and his team do the exact opposite. They look for information on what would make the company collapse. Berkowitz makes
extraordinary effort to be surprised by the upside
rather than shocked
by the downside.
But I have put so
much money in this!
A good practice
followed by most successful investors is to revisit
their investment decisions at regular intervals, and make changes
(including a complete
write-off, if needed) when necessary. A trap that the not-so-successful investors fall into is the 'sunk cost' fallacy, which makes them stick to an earlier position or
decision simply because a lot of time and money has been invested into that decision. Being a permanent
bear or a permanent bull is about falling
into the 'sunk cost
fallacy' trap.
(Accept that you can go wrong and come out of being wrong ASAP).
I am hopeful this
scrip will grow (this is how normal investors
think).
As we saw earlier, optimism (or hope) is the survival strategy
for humans from the caveman days. However, optimism is not necessarily good
when applied to investment decisions, and can be utterly disastrous if as an
investor, you are paying a premium for the hope of growth of the stock.
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Research indicates that in the US, the average
IPO has underperformed the market by 21% in the first three
years of the IPO rolling out.
Should you, then,
believe in hope
as an investment strategy? What is the recommendation then? As an investor, go back to the basics, stick
to facts, and let your
brain do the hard work
of the C system. That is what Ben Graham
suggested in 1934,
and it holds true even today.
Wow, it's a bubble!
A bubble, in its strictest sense, is defined as price movement
that is at least two standard deviations from the trend. Statistically, as per
the efficient markets hypothesis, this should happen every 44 years. However, there have been more than 30 bubbles since 1925! How can we, then, believe that markets are efficient?
Bubbles are actually
'predictable surprises' that explode into a crisis,
because the few people
who were aware
of the problems that led to the bubble, did not act on it. For every
bubble, there is always a set of people who caution against the bubble.
However, the challenge
is not in predicting the bubble, but in predicting the timing of when
the bubble will
burst and become
a crisis. Hence,
the term predictable surprise. People predict
a bubble but are surprised by the timing
of the bubble burst.
I was sure this bubble
will not burst
So why are we unable to tackle these
predictable surprises well in time? There are five reasons behind this
behaviour:
1. The over-optimism that we discussed earlier. We believe
in looking at the bright
side- others get divorced, I do
not. Similarly, others get caught
in a bubble burst; I will not.
2. The illusion of control that we carry within ourselves. TV channels churn out analysis
that makes us believe
that we have quantified the risk and therefore things
are well within
control. Only to get a nasty surprise later.
3. The self-serving and self-confirmation bias makes us believe only in information that meets our interests.
As Warren Buffet said 'Never ask a
barber if you need a haircut.'
4. We prefer spending more time
making choices that are geared towards the short term. When we make a decision that will bear results only in the future, we do not put too much of thought into it. However, when we
make a decision where the
consequences are in the near future, maybe next week, we think through our
choices with much more thought.
5. Finally, we miss spotting the bubble because
we are not
looking for it! We are so enthralled by the bubble
that we are not looking at the evidence of it bursting anytime soon.
Behavioural economics terms this as inattentional blindness.
The four most dangerous
words in investing
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The bubble framework based on Mill's paper captures the five
stages of a bubble
Displacement: This is the creation of profit opportunity, which though slow in the pace of growth, is the first stage of bubble creation. The slow growth
makes most people
miss it, but there are a few early spotters who have got in at this stage
of the bubble
Credit creation: Credit creation
acts like oxygen
for the bubble. The credit required to 'nurture' the bubble can come
from various sources
including money from banks, the creation of new credit
instruments or scaling
up of non-bank credit.
Euphoria: This is where
over-optimism comes in to make the bubble bigger. At this stage,
nothing about the bubble is wrong. All the behavioural economics concepts of optimism, self-serving bias, myopia, and inattentional blindness start manifesting themselves at scale. The common belief, as Sir John Templeton said, is 'This time is
different'. Those
are the most
dangerous four words
in investing.
Financial distress: This is the stage where the people who are aware of the problems behind
the bubble, the insiders, start cashing out. Instances of fraud emerge,
and the excessive leverage built during the earlier phases of the bubble leads
to a crisis.
Revulsion: the final stage in the life of a bubble
is where scarred
investors decide
to exit the bubble sector, or the market completely. This leads to a crash
and resultant bargain
price for the assets
involved in the bubble. As Mill
wrote 'Panics do not destroy
capital; they merely
reveal the extent
to which it has been
previously destroyed by its
betrayal into hopelessly unproductive works.
Bubbles
are formed due to human behaviour, and the good news is that human behaviour is
predictable.
Don't move!
In the 1950s & 1960s,
the average holding period of stocks
by investors was about
7-8 years. However, today, the average stock
holding period on the NYSE
is just six months. Being
myopic and thinking only
for the short term
is a malaise in the
investing world today. In addition to this myopia, things get
complicated by the need to keep showing that the fund manager is not sitting
idle. Instead, she or he is busy taking
steps to help your money grow.
In reality,
the best thing
to be done is to leave the portfolio alone.
We see action bias
as a positive thing. Research has shown that during
penalty shoot-outs in soccer,
the goalkeeper would
have saved more goals
by standing still at the center of the goal, instead
of jumping left or right. Yet, the
goalkeeper is expected to show action by
jumping left or right.
(In my 30 years of experience – I have
observed that NORMAL investors want actions every day!! They are there to make their
broker richer).
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Walk the path
alone
Neuroscientists
have found that there is fear and pain associated with the thought of going
against the crowd. Brain scans show that when the thought of going against the
crowd crops up, the amygdala portion of the brain becomes active. Amygdala is
the part of the brain that processes emotions and fear. Being contrarian requires
you to activate your brain's C-system, which requires much deliberate effort.
The contrarian
investor
As a contrarian
investor, you go against the crowd. When others buy, you sell. When others
sell, you buy. A note of caution is required here- due to our high sense of
self-esteem and optimism, we all believe that we are the contrarians, and
others conform to the herd. More often than not, we are mistaken and this
belief of being a contrarian when we are not coming from a lack of introspection
of our actions. Being a true contrarian in our lives, and as investors require
the following deliberate behavior
• Demonstrate
the courage to go against conventional wisdom and groupthink
• Practice critical
and independent thinking before making choices, including your investment
decisions
• Be
disciplined enough to stick to the path of being a contrarian. Grit matters.
When do I sell?
The best way to
decide when to sell is to stop focusing on the short-term. The more you keep
checking your portfolio, the more short-term loss scenarios will emerge, which
will make you sell. As human beings, we are averse to losses and like to cut
our losses as much as possible. When you keep checking your portfolio, you end
up looking at short-term losses, thereby succumbing to the need to cut your
losses by selling. If you have done your research well, your portfolio should
not require second-by-second monitoring.
Researchers
believe that the endowment effect plays a critical role in our decision to buy
or sell. The endowment effect happens when you, as compared to others, attach a
higher value to something that you own.
If you own a bottle
of wine whose price has appreciated ten folds in the past few years, will you
sell the wine bottle? The most common answer is a No. Will you now buy a
similar wine bole at ten times the price? The answer in most cases is, again, a
No. This is the endowment effect in play. Reluctance to sell is a common
behaviour of investors who are swayed by emotions and biases.
Focus on the
process, not the result
The
need to focus on the process rather than the result is the adage that
successful investors should swear by. Too much focus on the results leads to
sub-optimal choices on account of a desire to reduce losses and avoid
ambiguity. Instead, focusing on the process leads to beer decisions and higher
long-term returns.
As Ben Graham
said 'The value approach is inherently sound, devote yourself to that
principle. Stick to it, and do not be led astray. The best investors in the
world, including Warren Buffet, Bruce Berkowitz, John Templeton, and many others
have built their own processes or heuristics to arrive at a sound investment
decision. The only person standing between you and successful investment
decisions is you, and your errors and biases
Get your
C-system to consciously think and avoid biases.
What NEXT?
This is the best book to read after you have read yesterday’s book – The
Psychology of Money.
The more you explore yourself and understand yourself – the better you
will become in Investing.
Follow me on Twitter @hiteshmparikh Or
on Whatsapp
- +91-9869425399.
Live With Passion…Invest With Passion.
Hitesh Parikh.
ReplyDeleteThanks and Congratulations, Hitesh Bhai. Your each and every article is full of information and logical thinking too. Book Review is a superb. Thanks once again. Himanshu Shah, Author.