Monday, March 24, 2014

The Little Book of Behavioral Investing

Author James Montier promises to show you “How Not to Be Your Own Worst Enemy” in his Little Book of Behavioral Investing. He does this by going through a number of interesting ways we tend to make investing mistakes. In addition to being very interesting, this book is concise; it packs a lot of useful information into 219 small pages.

A common theme in this book is that it isn’t just dummies who make behavioural mistakes. In one test where people are given three very simple questions, even among MIT students and professional investors, less than half get all three answers right. The problem is that the questions are designed so that an obvious but incorrect answer suggests itself quickly. One of the questions is “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?” Other testing shows that the more of these three questions you get right, “the less likely you are to suffer extreme loss aversion.”

An experiment on willpower showed that hungry people who are made to resist eating cookies perform less well on a tedious task than those who were allowed to eat the cookies. Montier’s conclusion is that we have limited willpower and that “willpower alone is unlikely to be a sufficient defense against behavioral biases.” This may well be true, but another explanation for the experimental results is that we have less willpower when our blood sugar is low.

In an overconfidence experiment subjects are asked to give a 90% confidence range for things such as the diameter of the moon. Done properly, subjects should expect the correct answer to be inside the range they give in about 9 out of 10 questions. However, most people got only 4 to 7 ranges covering the correct answer. I got 10 out of 10 by simply admitting to myself that I really didn’t know the right answers with any degree of accuracy. In 3 of the 10 questions, though, the correct answer was very close to one end of the range I gave. Interestingly, weathermen were surprisingly good at this overconfidence test, but “doctors turn out to be a terrifying bunch of people. When they think they will be right 90 percent of the time they are actually correct only 15 percent of the time.”

An amusing subsection title is “Why Does Anyone Listen to Jim Cramer?” We are just drawn to people who make confident predictions no matter how often they are proved wrong. “Economists ... haven’t got a clue. Frankly, the three blind mice have more credibility.”

In a disturbing experiment on anchoring with judges, experimenters had each judge roll a pair of dice to simulate a prosecutor’s request for the length of a sentence for a particular crime. The dice were loaded to give a total of either 3 or 9. The judges who rolled 3 chose an average sentence of 5.3 months, and those who rolled 9 chose an average sentence of 7.8 months. Even though the judges themselves rolled the dice and knew the total was irrelevant, they were strongly influenced by the dice total.

Montier devotes a full chapter to confirmation bias. It’s hard to force yourself to seek out information that contradicts your beliefs. Fortunately for me, the stock market punished me enough (but not too much) that I had to admit eventually that I wasn’t a great stock picker. Now I buy index funds and do more interesting things with the time I used to spend poring over financial statements.

The author gives a puzzle about confirmation bias. Four cards have a number on one side and a letter on the other. “The four face-up symbols are E, 4, K, and 7. I’m going to tell you that if a card has an E then it should have a 4 on the reverse. Which cards would you like to turn over to see if I am telling the truth?” Amazingly, 95% of fund managers get this wrong.

People are more influenced by stories than by statistics even though a story generally has a statistical sample size of one. The author suspects that the reason why people continue to invest in IPOs despite their generally poor returns is because “stories overwhelm the evidence.”

To investors: “never underestimate the value of doing nothing.” Contrarian investing requires doing something different from the crowd, but this is the equivalent of “seeking out social pain.”

If readers can avoid the overconfidence of thinking that Montier’s teachings don’t apply to them, this book will show them valuable ways they can avoid costly investment mistakes.

2 comments:

  1. The behaviour tests included in Thinking Fast and Slow are also excellent.

    More and more, I'm learning how my investing brain ticks, for better or for worse.

    Mark

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    Replies
    1. @Mark: It took me a while to admit to myself that these behavioural biases applied to me, but they do. And I think I'm better able to protect against making mistakes by recognizing this fact.

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