The Little Book of Behavioral Investing

“We don’t 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.”- James Montier

In The Little Book Of Behavioral Investing, James Montier suggests that his most important lesson is that people tend to recognize cognitive biases in others rather than recognize that we ourselves are prone to cognitive biases. Even though biases seem to affect us all, we seem to have a biased blind spot. This biased blind spot can cost us money in investing, so this book discusses several destructive behavioral biases and common mental mistakes that Montier has seen professional investors make.

1. The Power of Pre-Commitment

   1. Investors should follow the seven P’s: “Perfect planning to prevent piss poor performance”. This means that we should plan our investments when we are in a logical and unemotional state of mind, instill a process and commit to it. For instance, impose a limit on what we are willing to pay when buying a stock.

   2. “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.”- Warre

2. The Illusion of Control

   1. We think we can influence the outcome and often mistake randomness for control. Also, the illusion of control enhances our optimistic tendencies.

   2. “The illusion of control seems most likely to occur when lots of choices are available; when you have early success at the task (as per the coin tossing); the task you are undertaking is familiar to you; the amount of information is high; and you have a personal involvement. To me, these sound awfully like the conditions we encounter when investing.”- James Montier

3. Optimism in Investing

   1. Optimism is a great life strategy but with investing, we have to be careful with optimism. Ben Graham noted that losses came from buying low-quality stocks during times of optimal business conditions. Prosperity when times are good does not equal safe stock picking.

   2. “The best solution may be to be clinically depressed at work, but happy and deluded when you go home.”- James Montier

4. The Self-Serving Bias

   1. Be careful when evaluating equity research because the reports tend to conform to three self-serving principles:

      1. All news is good news (if the news is bad, it can always get better)

      2. Everything is always cheap (even if you have to make up new valuation methodologies)

      3. Assertion trumps evidence (never let the facts get in the way of a good story)

5. The Folly of Forecasting

   1. Investment analysts like to forecast everything from earnings to future stock prices. Unfortunately, they are more wrong than they are right. Montiers says that we might be better off tossing a coin.

   2. “Some of the worst business decisions I have seen are those with future projections and discounts back to the present.”- Charlie Munger

6. Confidence Bias

   1. People tend to follow the advice given by experts who are confident with the subject. The power of confidence is so compelling that many even excuse a poor track record if something was told to them confidently.

   2. “Not only do we like our experts to sound confident, but our brain actually switches off some of our natural defenses when we are told someone is an expert.”- James Montier

7. Action Bias

   1. Action bias is the need to do something, but often the best thing to do in investing, which is also the most unintuitive, is to do nothing. We can all be enticed in by the prospect of quick results, which is why the get-rich-quick scheme never goes out of fashion. The solution is to have some patience, a process that we trust, and some discipline to stick to the process over the long term.

8. Confirmation Bias

   1. We are more likely to look for and listen to information that agrees with our conclusions than information that contradicts our decisions.

   2. “Time and again, psychologists have found that confidence and biased assimilation perform a strange tango. It appears the more sure people were that they had the correct view, the more they distorted new evidence to suit their existing preference, which in turn made them even more confident.”- James Montier

9. Sunk Costs Fallacy

   1. 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.

   2. “People tend to underreact in unstable environments with precise signals (turning points), but overreact to stable environments with noisy signals (trending markets). This helps explain why economists and analysts tend to miss turning points in the market. They get hung up on the stable environment and overreact to it; hence they miss the important things that happen when the environment becomes more unstable and underreact to such developments.”- James Montier

10. Social Pain

    1. Even if the crowd's view is not right, we often find it unsettling to go against the crowd. When we do, it can cause us to experience unease and fear.

    2. “Doing something different from the crowd is the investment equivalent of seeking out social pain. As a contrarian investor, you buy the stocks that everyone else is selling, and sell the stocks that everyone else is buying. This is social pain. The psychological results suggest that following such a strategy is really like having your arm broken on a regular basis—not fun!”- James Montier