As an investor, I find that it is very important to understand how the human brain works. Emotional turmoil, overconfidence, and biases are the three biggest traits that can make an investor lose everything. Behavioral finance recognizes that there is a psychological element to every investor decision making process. The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy by James Montier is a book that outlines the most frequently encountered psychological pitfalls of investing. In this week’s blog post, I will talk about the key takeaways from this Little Book of Behavioral Investing. Let’s dive in.
- Empathy Gap – The author talks about how we are prone to act in the heat of the moment. In other words, when there is a market selloff, although it is the right time to buy stocks, in the heat of the moment, the investor is likely to sell his holdings. Montier states that in order to avoid empathy gap, one has to prepare and pre-commit. He outlines the 7 P’s – Perfect Planning and Preparation Prevents Piss Poor Performance. Said differently, an investor should do his investment research in a cold rational state and commit to it.
- The author compares the investment approaches of different investors, and comes to the conclusion that there is no “right way” of investing. As a deep value investor, James Montier focuses on 3 elements: Valuation (Is this stock seriously undervalued?), Balance Sheets (Is this stock going bust?), Capital Discipline (What is the management doing with the cash I’m giving?). On the other hand, Montier points out that Warren Buffett’s investment approach can be summed up in one sentence: Buffett buys the companies at sensible prices when he knows that the underlying businesses have good to superb economics, and are run by honest and able people.
- There is a difference between analysis and forecasting. Analysis involves analyzing facts, and using sound principles and logic to draw conclusions. Forecasting is more speculative in nature. The author claims that there are 5 hurdles that prevent us from analyzing accurately: Overoptimism, Illusion of control, Self serving bias, Myophia, Inattentional blindness.
- The pain of going against the crowd – contrarian investing. Going against the crowd makes people scared. As a contrarian investor, you are buying the stocks that everyone else is selling, and you are selling the stocks that everyone else is buying. The author claims that such an investing strategy is like having your arm broken on a regular basis. However, in order to be successful, it is integral to be a contrarian investor.
- In order to stand against the crowd and reap the investment returns, one needs to have reasonably good intelligence, sound principles of operations, and firmness of character.
- Loss aversion – this is people’s tendency to prefer avoiding losses to making an equivalent gain. For example, people prefer not losing $100 than to winning $100. Loss aversion is seen everywhere from gambling to making par puts in golf. Loss aversion is also the reason why you stick with your losses, because even though you are losing, that loss wouldn’t materialize until you sell your losing stock.
- Endowment effect – this tendency goes alongside loss aversion. Endowment effect is when people are more likely to retain a stock they own than acquire that same stock when they do not own it. This is precisely why it can be difficult for people to part ways with their holdings.
- In investing, it is critical to focus on the process rather than the outcome. Since time plays a big part in investing, you could be right over a 5 year timeline, but wrong over a 6 month timeline. Process Accountability could counter those sunk cost fallacy decision. By focusing on process, investors tend to generate good, long term returns. So, focusing on process leads to better decisions.
Overall, I thought this 5 hour audio book was definitely worth a listen. It went over some great information about biases and how to avoid any pitfalls caused by misjudgment. I would recommend this book to anyone who wants to get more control over his/her investing decision making process.
Hope you learned a little and found this blog post helpful. We talked about the key takeaways from James Montier’s Little Book of Behavioral Investing. As always, you can sign up for our free mailing list here. You can sign up for our paid subscription services here. Like us on our Facebook page here. Thank you!
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