The Little Book of Behavioral Investing E-Book

Montier James

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Little Books. Big Profits (UK)
• Sprache: Englisch
• Veröffentlichungsjahr: 2010

Seitenzahl: 223

Beschreibung

A detailed guide to overcoming the most frequently encountered psychological pitfalls of investing Bias, emotion, and overconfidence are just three of the many behavioral traits that can lead investors to lose money or achieve lower returns. Behavioral finance, which recognizes that there is a psychological element to all investor decision-making, can help you overcome this obstacle. In The Little Book of Behavioral Investing, expert James Montier takes you through some of the most important behavioral challenges faced by investors. Montier reveals the most common psychological barriers, clearly showing how emotion, overconfidence, and a multitude of other behavioral traits, can affect investment decision-making. * Offers time-tested ways to identify and avoid the pitfalls of investor bias * Author James Montier is one of the world's foremost behavioral analysts * Discusses how to learn from our investment mistakes instead of repeating them * Explores the behavioral principles that will allow you to maintain a successful investment portfolio Written in a straightforward and accessible style, The Little Book of Behavioral Investing will enable you to identify and eliminate behavioral traits that can hinder your investment endeavors and show you how to go about achieving superior returns in the process. Praise for The Little Book Of Behavioral Investing "The Little Book of Behavioral Investing is an important book for anyone who is interested in understanding the ways that human nature and financial markets interact." --Dan Ariely, James B. Duke Professor of Behavioral Economics, Duke University, and author of Predictably Irrational "In investing, success means¿being on the right side of most trades. No book provides a better starting point toward that goal than this one." --Bruce Greenwald, Robert Heilbrunn Professor of Finance and Asset Management, Columbia Business School "'Know thyself.' Overcoming human instinct is key to becoming a better investor.¿ You would be irrational if you did not read this book." --Edward Bonham-Carter, Chief Executive and Chief Investment Officer, Jupiter Asset Management "There is not an investor anywhere who wouldn't profit from reading this book." --Jeff Hochman, Director of Technical Strategy, Fidelity Investment Services Limited "James Montier gives us a very accessible version of why we as investors are so predictably irrational, and a guide to help us channel our 'Inner Spock' to make better investment decisions. Bravo!" --John Mauldin, President, Millennium Wave Investments

Leseprobe

Table of Contents

Little Book Big Profits Series

Title Page

Copyright Page

Dedication

Foreword

Introduction

The Most Important Lesson of All

The Power of Star Trek

So, Are You Spock or McCoy?

X Unchecked

Chapter One - In the Heat of the Moment

The Perils of Procrastination

The Power of Pre-Commitment

Chapter Two - Who’s Afraid of the Big Bad Market?

Brain Drain and Performance

The Cure for Temporary Paralysis

Chapter Three - Always Look on the Bright Side of Life

Optimism and the X-System

Nature versus Nurture

Beating Over-Optimism

Chapter Four - Why Does Anyone Listen to These Guys?

Why Does Anyone Listen to Jim Cramer?

The Shocking Dangers of Doing What We Are Told

Fund Managers: Weathermen or Doctors?

Overconfidence May Be Hazardous to Your Wealth

Chapter Five - The Folly of Forecasting

So, Why Do We Keep Forecasting?

Why Do We Use Forecasts?

There’s Got to Be a Better Way

Chapter Six - Information Overload

Is More Better?

When Less Is More

From the Emergency Room to the Markets

Chapter Seven - Turn off That Bubblevision!

Meet Mr. Market

Chapter Eight - See No Evil, Hear No Evil

The Sorry Tale of Sir Roger

Prisoners of Our Preconceptions

Kill the Company

Chapter Nine - In the Land of the Perma-Bear and the Perma-Bull

Hanging onto Your View

Sunk Costs at the Root of Conservatism

Chapter Ten - The Siren Song of Stories

Stock Market Stories

Beware of Capitalizing Hope

Focus on the Facts

Chapter Eleven - This Time Is Different

Why Can’t We Time Predictable Surprises?

A Beginner’s Guide to Spotting Bubbles

Your Edge Over the Pros!

Chapter Twelve - Right for the Wrong Reason, or Wrong for the Right Reason

It’s Not My Fault, It’s Just Bad Luck

Don’t Be a Monday Morning Quarterback

Chapter Thirteen - The Perils of ADHD Investing

What Can We Learn from Goalkeepers?

Poor Performance Increases the Desire to Act

Investors and Action Bias

Waiting for the Fat Pitch

Chapter Fourteen - Inside the Mind of a Lemming

The Pain of Going against the Crowd

The Carrot of Conformity

The Dangers of Groupthink

Alone in a Crowd of Sheep

Chapter Fifteen - You Gotta Know When to Fold Them

We Are Not Alone (or Perhaps Not Even That Evolved!)

Myopia and Loss Aversion

Why You Can’t Bring Yourself to Sell

The Endowment Effect

Chapter Sixteen - Process, Process, Process

The Psychology of Process

Process Accountability

Conclusion

Little Book Big Profits Series

In the Little Book Big Profits series, the brightest icons in the financial world write on topics that range from tried-and-true investment strategies to tomorrow’s new trends. Each book offers a unique perspective on investing, allowing the reader to pick and choose from the very best in investment advice today.

Books in the Little Book Big Profits series include:

The Little Book That Beats the Market by Joel Greenblatt The Little Book of Value Investing by Christopher Browne The Little Book of Common Sense Investing by John C. Bogle The Little Book That Makes You Rich by Louis Navellier The Little Book That Builds Wealth by Pat Dorsey The Little Book That Saves Your Assets by David M. Darst The Little Book of Bull Moves in Bear Markets by Peter D. Schiff The Little Book of Main Street Money by Jonathan Clements The Little Book of Safe Money by Jason Zweig The Little Book of Behavioral Investing by James Montier

Copyright © 2010 by John Wiley & Sons, Ltd. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at www.wiley.com/go/permissions.

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eISBN : 978-0-470-71203-0

To Charlotte Your smile lights up my world

Foreword

Homo Mistakus

I AM RATHER AN EXPERT ON BAD CHOICES. I have made so many over the years, from unhealthy food choices to postponing exercise (today’s bad choice) and yes, even regrettable investment choices (sigh).

And then I have observed so many bad choices on the part of my seven teenagers. (Thankfully, now down to just one, but these days I get to watch my grandkids learn to navigate the world.) Teenagers have a remarkable ability to make the easy choice today and postpone the hard and difficult choice until tomorrow. And some of us grow up, having perfected that ability, making even more bad choices as adults.

I have interviewed hundreds of investors over the years, from small and starting out to having-arrived billionaires. I am always amazed by the mistakes they make and the inventive rational they use for having made them.

As a nation and a world, we have made numerous bad choices, taken the easy road, and ended up in the worst global economic crisis in 80 years. Now we are faced with a set of difficult choices as we work our way back to a new normal. History is replete with bad choices by both individuals and nations.

In the past few decades, a new science has emerged that has taken note of the fact that not only are we sometimes irrational, but we are predictably irrational. This new behavioral science has started looking at how we go about making decisions and is finding all sorts of interesting, if sometimes distressing, things about the human species.

It seems that our emotions and much of our decision-making process is hard wired into our brains, developed for survival on the African savannahs some 100,000 years ago. We adapted to movement, learning to make decisions quickly, because there was quite a difference, literally life and death, between dodging dangerous lions and chasing succulent antelope.

And while those survival instincts are quite useful in general, when translated into a modern world, and especially a modern investment world, they make us prone to all sorts of errors. Think of chasing momentum all too often in the hope that it will continue and running from falling markets just as they start to turn. What works for survival in the African jungles is not as productive in the jungles of world finance.

Happily, we are not just homo mistakus. If we had learned to make nothing but bad choices our species would have been consigned to the dust bin of history a long time ago, making room for some survivors less prone to error.

We clearly learned to make good choices as well, and to learn from our mistakes and even the success and wisdom of others. As I mentioned earlier, I have formally interviewed hundreds of millionaires. I am even more fascinated by choices they made that were the good (and sometimes brilliant!) ones, and the processes they used to make them.

As a human species, there is much to be admired about homo sapiens. We are capable of great work, soaring ideas, and wonderful compassion, all the results of good choices. And behavioral science is helping us to understand how we make those choices.

Even as what was once considered the foundations of finance (the efficient market hypothesis, CAPM, and modern portfolio theory) are being questioned and even blamed for much of the problems in the markets, many of us are looking to the new world of behavioral finance for answers to our investment conundrums. By understanding ourselves and the way we make decisions, we can often create our own systematic process for making the right choices. Whereas we once seemed to be adrift in an ocean of potential choices, with our emotions often dictating the final outcome, with the right tools we can learn to set a confident course to that safe port of call.

The problem is that behavioral finance can seem a little daunting, full of studies and inferences, and not tied together very well—until now, that is. My good friend James Montier, who literally wrote the book on behavioral finance, called Behavioural Finance: Insights into Irrational Minds and Markets, has now put his considerable knowledge into this small tome, The Little Book of Behavioral Investing.

I am no stranger to James’ work. He and I worked on a lengthy chapter on behavioral finance for my book, Bull’s Eye Investing (John Wiley & Sons). I thought I was familiar with the subject. But taking the Little Book on a plane ride was one of the best investments of reading time I have had in years. I found myself on all too many occasions sadly admitting to myself, “That’s me!” and sighing, vowing to never again make that mistake. But at least I now know what to avoid, and I can work to improve my habits.

This is a book that I am going to have to read often, at least annually. Thankfully, James has made the book fun and the subject interesting. His naturally wry humor comes through. Whether learning why we can’t seem to sell when we should, or why we choose our price targets, James gives us a blueprint to becoming better investors in 16 little chapters full of insight. No more homo mistakus!

I suggest you put this book on the top of your reading pile, and keep it near your desk, so you can refer to it often—to help keep you calm in the heat of the decision-making moment. So, sit back, and let James help bring out your inner Spock!

John Mauldin

Introduction

This Is a Book About You: You Are Your Own Worst Enemy

HOW COULD I POSSIBLY WRITE A BOOK ABOUT YOU? After all, chances are we ’ve never met. Let alone that I know you well enough to write a book about you! The answer is actually very simple: You are a human being (unless the sales of this book have managed to reach interplanetary proportions—evidence of extreme over-optimism on my part perhaps), and we humans are all prone to stumble into mental pitfalls. This is as true in investing as it is in every other walk of life. Indeed, Ben Graham (the father of value investing) even went so far as to say “The investor’s chief problem—and even his worst enemy—is likely to be himself.”

Evidence of this harmful investor behavior can be found in the annual Dalbar studies, which measure the actual returns achieved by investors rather than the returns from a passive index, such as the S&P 500. They also capture the degree to which investors attempt to time their entry and exit to the market (among other things). The results aren’t pretty. Over the last 20 years, the S&P 500 has generated just over 8 percent on average each year. Active managers have subtracted 1 or 2 percent from this, so you might be tempted to think that individual investors in equity funds would have earned a yearly 6 to 7 percent. However, equity fund investors have managed to reduce this to a paltry 1.9 percent per annum. This results from buying and selling at just about the worst possible point in time. Sure looks like Ben Graham was right—we really are our own worst enemies.

The goods news is that it doesn’t have to be this way. We can learn to make better decisions—it isn’t easy, but it is possible. The Little Book of Behavioral Investing will take you on a guided tour of the most common behavioral challenges and mental pitfalls that investors encounter and provide you with strategies to eliminate these innate traits. Along the way, we ’ll see how some of the world ’s best investors have tackled the behavioral biases that drag down investment returns, so that you hopefully will be able to learn from their experiences and go on to make superior returns and have fewer losses.

The Most Important Lesson of All

Whenever I teach behavioral psychology I see the audience recognizing the mental mistakes that I am talking about. However, most of the time they recognize the mistake in others, rather than in themselves. It is always Bill the trader, or Pete the portfolio manager, who illustrates the bias rather than us. We all seem to have a bias blind spot.

For instance, a group of Americans were asked to assess how likely the average American was to make a particular mental error, and how likely they themselves were to make exactly the same mistake.1 The bias blind spot kicked in. The survey participants thought the average American was always more likely than they were to make a mental mistake.

However, the evidence that has been collected over the course of the last three or four decades shows that all of us are likely to encounter mental stumbling blocks at some point. So the single most important lesson I could hope to share with anyone is that the biases and mistakes we are talking about in this book are likely to affect every one of us.

Why do we all suffer these behavioral biases? The answer lies in the fact that our brains have been refined by the process of evolution, just like any other feature of our existence. But remember, evolution occurs at a glacial pace, so our brains are well designed for the environment that we faced 150,000 years ago (the African savannah) but potentially poorly suited for the industrial age of 300 years ago, and perhaps even more ill-suited for the information age in which we currently live.

As Douglas Adams, author of the sublime Hitchhikers Guide to the Galaxy, said, “Many were increasingly of the opinion that they ’d all made a big mistake in coming down from the trees in the first place. And some said that even the trees had been a bad move, and that no one should ever have left the oceans.” Leaving the trees (or perhaps the oceans) may have been our first mistake, but it certainly wasn’t our last.

The Power of Star Trek

Psychologists have suggested that the best method of thinking about the way in which our brains work is to imagine that we have two different systems embedded within our minds. For the Trekkies out there, these two systems can, perhaps, be characterised as Dr. McCoy and Mr. Spock. McCoy was irrepressibly human, forever allowing his emotions to rule the day. In contrast, Spock (half human, half Vulcan) was determined to suppress his emotions, letting logic drive his decisions. Just in case you are the only person on this planet who has never come across Star Trek, the Vulcans were a humanoid species who were noted for their attempt to live by reason and logic with no interference from emotion.

The McCoy part of our brains, which we will call the X-system, is essentially the emotional approach to decision making. The X-system is actually the default option, so all information goes first to the X-system for processing. It is automatic and effortless. The judgments made by the X-system are generally based on aspects such as similarity, familiarity, and proximity (in time). These mental short-cuts allow the X-system to deal with large amounts of information simultaneously. Effectively, the X-system is a quick and dirty ‘satisfying’ system, which tries to give answers that are approximately (rather than precisely) correct. In order for the X-system to believe that something is valid, it may simply need to wish that it were so.

The Spock part of our brains, which we will call the C-system, is a more logical way of processing information. It requires a deliberate effort to actually engage this system. It attempts to follow a deductive, logical approach to problem solving. However, it can only handle one step at a time (like any logical process), so it is a slow and serial way of dealing with information. Evidence and logic will be required to make the C-system believe that something is true.

Of course, we all read this and think that we are Spock. However, the reality is that the X-system handles far more of our actions than we would be comfortable to admit. In fact, very often we end up trusting our initial emotional reaction, and only occasionally do we recruit the C-system to review the decision. For instance, when we stub a toe on a rock, or bang our head on a beam (an easy thing to do in my house), we curse the inanimate object despite the fact that it could not have done anything to avoid our own mistake!

Neuroscientists have found that the parts of the brain associated with the X-system are much older, evolutionarily speaking, than the parts of the brain associated with the C-system. This is to say we evolved the need for emotion before we evolved the need for logic. This might sound odd, but an example should help make the point obvious. Let’s pretend that I place a glass box containing a large snake on the table in front of you. I ask you to lean forward and concentrate on the snake. If it rears up you will jump backwards (even if you aren’t afraid of snakes).

The reason for this reaction is that your X-system reacted to keep you safe. In fact, a signal was generated the second your brain perceived the snake moving. The signal was sent on two different paths—a low road and a high road, if you like. The low road was part of the X-system, and sent the information straight to the amygdala (the brain’s center for fear and risk). The amygdala reacts quickly, and forces the body to jump backwards.

The second part of the signal (taking the high road) sent the information on a long loop around to part of the C-system, which processes the information in a more conscious fashion, assessing the possible threat. This system points out that there is a layer of glass between you and the snake. But you have already reacted by this time. From a survival point of view, a false positive is a better response than a false negative. Emotion is designed to trump logic.

So, Are You Spock or McCoy?

Of course, we all use both systems at various points. Indeed, the evidence suggests that those with severely impaired X-systems can’t make decisions at all. They end up spending all day in bed pondering the possibilities, without actually engaging in any action.

However, from an investment perspective we may well be best served by using our C-system. Lucky for us, we can test how easy it is to override the X-system. Shane Frederick of Yale (formerly of MIT) has designed a simple three-question test which is more powerful than any IQ test or SAT score at measuring the ability of the C-system to check the output of the X-system.2 Together these three questions are known as the Cognitive Reflection Task (CRT).

Consider the following three questions:

1. 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?

2. If it takes five minutes for five machines to make five widgets, how long would it take 100 machines to make 100 widgets?

3. In a lake there is a patch of lily pads. Every day the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?

Now each of these questions has an obvious, but unfortunately incorrect answer, and a less obvious but nonetheless correct answer. In question #1 the quick and dirty system favors an answer of $.10. However, a little logic shows that the correct answer is actually $.05.

In question #2 the gut reaction is often to say 100 minutes. However, with a little reflection we can see that if it takes five machines five minutes to produce five widgets, the output is actually one widget per machine per five minutes. As such, it would take 100 machines five minutes to make 100 widgets.

Finally, in question three, the most common incorrect answer is to halve the 48 days and say 24 days. However, if the patch doubles in size each day, the day before it covers the entire lake, it must have covered half the lake, so the correct answer is 47 days.

Don’t worry if you got one or all three of those questions wrong—you aren’t alone. In fact, after giving the test to nearly 3,500 people, Frederick found that only 17 percent of them managed to get all three questions right. Thirty-three percent got none right! The best performing group were MIT students; 48 percent of them managed to get all three questions correct—but that is still less than half of some of the best students in the world. I ’ve had 600 professional investors (fund managers, traders, and analysts) take these questions and only 40 percent managed to get all three questions correct, while 10 percent didn’t get any right.

What does this tell us? It tells us that all humans are prone to decision making using the X-system, and this is often unchecked by the more logical C-system. I’ve found that the number of Frederick’s questions that you get correct correlates with your general vulnerability to a whole plethora of other behavioral biases, such as loss aversion, conservatism, and impatience. Those who get zero questions right seem to suffer more pronounced examples of the biases than those who get three questions right.

Just in case you got all three questions right and are now about to abandon this book, I would caution that two very important biases seem to be immune to the power of the CRT. No matter how well you scored on the CRT you are still likely to encounter a couple of specific mental pitfalls—namely over-optimism, overconfidence, and confirmatory bias. These will be explored in the coming chapters.

X Unchecked

When are we most likely to reply upon our X-System to help us out? Psychologists3 have explored this question and come up with the following conditions which increase the likelihood of X-system thinking:

• When the problem is ill structured and complex.

• When information is incomplete, ambiguous, and changing.

• When the goals are ill defined, shifting, or competing.

• When the stress is high, because either time constraints and/or high stakes are involved.

• When decisions rely upon an interaction with others.

Now I don’t know about you, but pretty much every decision of any consequence that I’ve ever had to make has fallen into at least one or more of those categories. It certainly characterizes many of the decisions that we make when faced with an investment proposition.

One of the world ’s greatest investors, Warren Buffett, has said that investors need to learn to control their X-system, “Success in investing doesn’t correlate with IQ once you’re above the level of 100. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

But before we conclude that we have solved all of our behavioral errors, we should be aware that self-control (the ability to override our urges) is like a muscle—after use it needs time to recharge. To illustrate this point, think about the following experiment.4

You are told not to eat any food for the three hours prior to the exercise (actually timed so you have to skip lunch). When you arrive at the lab you are put into one of three groups.

The first group is taken into a room where the aroma of freshly baked chocolate chip cookies is wafting around. This room contains two trays, one laid out with freshly baked chocolate chip cookies, the other full of radishes. The group is told they can eat as many radishes as they would like, but they mustn’t eat the cookies. The second group is more fortunate. They too are faced with two trays, each containing the same foods as for the first group, but this group is told they can eat the cookies. The third group is taken to an empty room.

After 10 minutes all the groups are collected and moved to another room to take a test. The test is one of those tricky ones where you are told you must trace a shape, but do so without going over a line you have drawn before and without lifting your pen from the paper.

How do you think people from each grouped fared in the test? Those who were forced to resist the temptation of freshly baked cookies and content themselves with radishes gave up on the test in less than half the time of those from the other two groups; they also attempted just half as many problems! Their willpower had been diminished by simply resisting the temptation of cookies.

These results suggest that relying upon willpower alone is going to be tricky. Resisting the chocolate cookie that beckons to us may lead to a poor investment choice. Willpower alone is unlikely to be a sufficient defense against behavioral biases.