Book Notes: "The Little Book of Behavioral Investing" by James Montier

Empathy Gap - the inability to predict our own future behavior under emotional strain

The Perils of Procrastination - that dreadful urge you suffer, when you know there is work to be done, to put it off for as long as possible.

The Power of Pre-Commitment - a possible weapon to place in our arsenal against the behavioral pitfall of Empathy Gaps and Procrastination

Investors should learn to follow the 7 P's:

Perfect Planning and Preparation Prevent Piss Poor Performance

That is to say, we should do our investment research when we are in a cold, rational state, and when nothing much is happening in the markets - and then precommit to following our own analysis and prepared action steps.

Sir John Templeton says "The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell". He always kept a "Wish List" of securities representing companies that he believed were well run but priced too high. He knew that on the day the market or stock was down he wouldn't have the discipline to execute a buy. By placing buy orders well below the market price, it becomes easier to buy when faced with despondent selling. This is a simple but highly effective way of removing emotion from the situation.

Who's Afraid of the Big Bad Market? Re-Investing when terrified

Fear causes people to ignore bargains when they are available in the market, especially if they have previously suffered a loss. The longer they find themselves in this position, the worse their decision-making appears to become.

Seth Klarman notes "We have often described our techniques for accomplishing this: 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."

Always Look on the Bright Side of Life - But, Why Should I Own This Investment?

The tendency to overrate our abilities is amplified by the illusion of control - we think we can influence an outcome. The illusion of control seems most likely to occur when lots of choices are available; when you have early success at the task; the task you are undertaking is familiar to you; the amount of information is high; and you have a personal involvment.

Beating Over-Optimism

We must learn to think critically and become more skeptical.

Most of the best investors appear to ask themselves a very different default question from the rest of us. Many of these investors generally run concentrated portfolios, with the default question being "WHY SHOULD I OWN THIS INVESTMENT?"

Spencer Davidson of General American Investors used to always say "We were in the rejection business - that we're paid to be cynical and that a big part of success in investing is knowing how to say NO"

Stop Listening to the Experts! Our species has an unfortunate habit of using confidence as a proxy for skill.

Prepare - Don't Predict

Lao Tzu observed "Those who have knowledge don't predict. Those who predict don't have knowledge."

Ben Graham pointed out "Analysis should be penetrating not prophetic". That is to say, analysts are called analysts, not forecasters, for a reason. All investors should devote themselves to understanding the nature of the business and its intrinsic worth, rather than wasting their time trying to guess the unknowable future.

In my opinion, the key to dealing with the future lies in knowing where you are, even if you can't know precisely where you're going. Knowing where you are in a cycle and what that implies for the future is different from predicting the timing, extent and shape of the cyclical move.

Information Overload - Distinguishing the Signal from the Noise

When it comes to investing, we seem to be addicted to information.

J. Boorstin opined "The greatest obstacle to discovery is not ignorance - it is the illusion of knowledge."

It is far better to focus on what really matters, rather than succumbing to the siren call of Wall Street's many noise peddlers.

It's time to prove yourself Wrong

We are too busy looking for information that confirms our hypothesis.

Karl Popper argued that the only way to test a hypothesis was to look for all the information that disagreed with it.

Not only do we look for information that agrees with us, but we tend to see all information as supporting our hypothesis.

We need to learn to look for evidence that would prove our own analysis wrong. It essentially turns the investment viewpoint upside down. By looking at the ways in which things can go wrong, rather than looking for all the evidence that everything is going well.

When the Facts Change, Change Your Mind

Hanging onto your view - this behavioral pitfall is observed frequently in the financial world.

People underreact to things that should make them change their minds.

What is the root cause of this Conservatism? The answer seems to me to lie in the "Sunk Cost" fallacy. This is a tendency to allow past unrecoverable expenses to inform current decisions. We tend to hang onto our views too long simply because we spent time and effort in coming up with those views in the first place.

Rather than hanging onto our views. what we should have done is give ourselves a blank sheet of paper, imagine our positions were 0, and say to ourselves "Given what we now know, would we open a fresh long or new short?". If the answer is Yes and it corresponds to a position, then fine. However, if the answer is No, but the position is still running, then it should be closed out.

Focus on the Facts

What can we do to guard against the siren song of stories? We must focus on the facts. Stories usually have an emotional content, hence they appeal to the X system - the quick and dirty way of thinking. If you want to use the more logical system of though (the C system), then you must focus on the Facts.

Ben Graham insisted that "Safety must be based on study and standards," and that valuation be "justified by the facts, e.g., the assets, earnings, dividends, definite prospect, as distinct from market quotations established by artificial manipulation or distorted by psychological excesses."

This Time is Different

What prevents us from seeing the Predictable Surprises?

At least 5 major psychological hurdles hamper us.

1. Over-Optimism

2. Illusion of Control - the belief that we can influence the outcome of uncontrollable events

3. Self-Serving Bias - the innate desire to interpret information and act in ways that are supportive of our own self-interests.

4. Myopia - an overt focus on the short term

5. Inattentional Blindness - we simply don't expect to see what we are not looking for

Right for the Wrong Reason

Self-attribution Bias is our habit of attributing good outcomes to our skill as investors, while blaming bad outcomes on something or somebody else.

To combat the pervasive problem of Self-attribution we really need to keep a written record of the decisions we take and the reasons behind those decisions - an Investment Diary. A real-time Investment Diary can be a very 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.

Never Underestimate the Value of Doing Nothing

Not only do we desire quick results but we love to be seen as doing something; we have a distinct bias towards Action.

The urge to act tends to intensify after a loss - a period of poor performance.

Paul Samuelson opined "Investing should be dull. It shouldn't be exciting. Investing should be more like watching paint dry or watching grass grow."

Blaise Pascal said "All men's miseries derive from not being able to sit in a quite room alone."

PROCESS - The One Thing You Can Control

Psychological evidence shows that focusing on outcomes can create all sorts of unwanted actions.

Focus upon process frees us up from the worrying about aspects of investment which we really can't control. Process is the set of rules that govern how we go about investing.

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