There’s a huge amount of psychology in investing, with many investment decisions being driven by emotion rather than logic. This area of research is known as Behavioral Finance and it attempts to understand why people make irrational investment decisions. You may have made some emotional investment decisions in the past, but chances are you’ll quite likely deny it as you’ve convinced yourself it was entirely rationale and logical. Here’s my review of The Little Book of Behavioral Investing: How not to be your own worst enemy (Little Books, Big Profits (UK))
I read this book because it’s a general introduction to this subject and I wanted to know more. It’s a fairly easy read and it’s split into 16 short chapters, each covering a different aspect of investing psychology. There are several quizzes and puzzles, and a lot of experimental / laboratory results to illustrate topics and it’s a fairly lively read.
The author of the book, James Montier, is clearly a value investor and lessons from Ben Graham are spread liberally throughout the book. He even starts out with Ben Graham’s quote, “The investor’s chief problem – and even his worst enemy – is likely to be himself.” He includes wisdom from other famous investors along the way too, including Warren Buffet and John Templeton.
This book doesn’t provide any investment strategies, nor does it go into any analysis of what makes a ‘good’ investment or how to determine if something is fair-value. What it does do, is to highlight some thoughts and behaviors that affect you which you might not be aware of. It’s up to you to decide how to use that knowledge.
One premise in the book is the generalization that your brain has two ways of thinking – there’s the ’emotional’ side which is fast, responsive and natural; then there’s the ‘logical’ side which is slower to process and answer. A very simple example of this is at the zoo if you’re looking at a lion in a cage and it suddenly charged towards you. Your initial (emotional) reaction would be to step back, despite the (logical) realization that the lion couldn’t get through the bars. Investing requires use of the logical part of the brain, the emotional side tends to led you astray.
As an example mentioned in the book, consider a bat and a ball that together cost $1.10. If the bat costs $1 more than the ball, what does the ball cost?
If your initial thought was that the ball costs $0.10 like me, then you’d be wrong and you used your emotional side of your brain to quickly approximate and answer the question.
The book starts with a short discussion on the empathy gap which is the inability to control behavior under emotional stress – you may have come across this from the advice “never go supermarket shopping when you’re hungry” since you’ll buy more. Forward looking plans and pre-committed decisions are remedies proposed here. Likewise being afraid to invest during a stock market crash or bear market in case you lose even more money.
Optimism is also discussed and how people tend to over-estimate, especially when there’s an illusion of control for example in guessing the result of a previous coin flip and being more confident about the next flip. Jim Cramer also gets a mention on account that the knowledge someone is an ‘expert’ can automatically bias your thoughts and combine with people’s general tendency to trust things said with confidence.
Female investors in particular did better than men in net performance in one study cited by the book; they tended to buy and hold compared to men who were more confident of their investing skills traded more actively.
Attempting to forecast price / total return of stocks is another topic of the book. Here analysts have prepared many excuses for why their forecasts didn’t come to pass:
- The Scooby Doo defense (my term): “if it wasn’t for those pesky kids…” aka the ‘if-only’ defense
- “<whatever reason> was outside the scope of my model”
- “I was nearly right”
- “It just hasn’t happened yet”
- “You can’t judge me from one failed forecast”
Remedies here include suggestions from Ben Graham – “Analysis should be penetrating, not prophetic.“. Anchoring is discussed here too which is where the value of something is influenced by an arbitrary price point; the arbitrary price becomes the “normal” price and price changes become relative to that baseline and are no longer absolute.
I found the concept of too much information causing increased confidence but reduced accuracy quite interesting. Investors generally felt more confident the more data points that could be compared, but the accuracy of those decisions was less. There’s no right or wrong answer here but some advice is to concentrate on up to 5 characteristics of the company being considered; per Warren Buffet “we just try to buy businesses with good to superb underlying economics run by honest and able people and buy them at good prices.”
Another area to challenge yourself is not to ask “why should I buy this stock?” but rather “why shouldn’t I buy this stock?”. There’s a natural tendency to favor conformational bias to support a decision to do something over arguments not to do something. For example, you might think a stock is great value and end up choosing data to make it look like great value. I’ve seen comments to the effect of “I usually only buy stocks within some parameter, but in this case I’m going to make an exception,” in several stock analysis which suggests this kind of bias to me.
Interestingly enough, one piece of advice was about documenting your purchases in a diary or other form; to have a record of why you decided to purchase something. This helps you learn from any mistakes made as you can view the original decision behind that investment. And it touches upon another theme in the book, of having a process to guide your decisions. The outcome of which can be summarized by
|Good Result||Bad Result|
|Good Process / Reasoning||Deserved success||Bad break|
|Bad Process / Reasoning||Dumb luck||Poetic justice|
Hopefully most of you are buy and hold investors, but it’s interesting to see statistics about the average holding period of stocks on the New York stock exchange – in the 1950’s and 60’s this used to be 6/7 years; now it’s nearer 6 months.
The book wraps up with a discussion on Contrarian investing and going against the crowd behavior (having only a few people in agreement can influence someone else’s viewpoint) and loss aversion (when to hold vs. sell).
I’d definitely recommend finding a copy at your local library if you’ve not read it already.