James Montier’s Lessons on Behavioral Investing

“We will learn an enormous amount in the short term, quite a bit in the medium term and absolutely nothing in the long term. That would be the historical precedent.” – Jeremy Grantham

(1) 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?

(2) If it takes 5 minutes for 5 machines to make 5 widgets, how long would it take 100 machines to make 100 widgets?

(3) In a lake there is a patch of lily pads. Every day the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?

Your intuitive answers to these questions were probably $0.10, 100 minutes and 24 days (see the end of the post for the actual answers).

Don’t feel bad if you got these questions wrong. The majority of the people who have answered them in the past have as well. I’ve seen all of these questions multiple times and it still takes me a while to get past the intuitive answers and think them through all the way.

Why does our brain do this to us? Why does it try to take the easy way out without taking the time to think through our problems?

That’s what James Montier tries to explain in The Little Book of Behavioral Investing. Montier goes through study after study to show why we have such a hard time with our decisions and gives solid advice from many of the greatest investors.

Here are some of the lessons from this wonderful little book along with my comments:

Willpower alone is unlikely to be a sufficient defense against behavioral biases. Trying harder doesn’t create change. You need systems.

Buy when it’s cheap – if not then, when? This is the buy low portion of the oldest investment advice in the book.

People will pay four times more for a lottery ticket if they can pick the numbers, as opposed to a ticket with randomly selected numbers (as if they can control the outcome). Do not try to control that which you have no control over.

Typical stock broker research: (1). All news is good news (if the news is bad, it can get better), (2). Everything is always cheap (even if you have to make up new valuation methodologies) and (3). Assertion trumps evidence (never let the facts get in the way of a good story). Sound familiar? This sums up the majority of Wall Street research that you hear these days.

Experts are even more confident than the rest of us. People prefer those who sound confident and are even willing to pay more for confident (but inaccurate) advisors. Don’t mistake confidence for intelligence.

We need to stick to our investment discipline, ignore the actions of others, and stop listening to the so called experts. Don’t be a contrarian just for the sake of being a contrarian because value matters, but herd mentality is what causes markets to get out of whack at the extremes.

It would be sheer madness to base an investment process around our seriously flawed ability to divine the future. We would be better off if we took Keynes’ suggested response when asked about the future, “We simply do not know.” I don’t know are the three least used words on Wall Street.

The key to dealing with the future lies in knowing where you are, even if you can’t know precisely where you’re going. Having a historical perspective on the markets and using it to gauge the current environment is the best way to understand where we are likely to be in the market’s current cycle, even if you can’t know for sure.

We tend to hang onto our views too long simply because we spent time an effort coming up with those views in the first place. This leads to confirmation bias and an anchoring to strongly held beliefs even if the evidence fails to support them anymore.

Part of the problem for investors is that they expect investing to be exciting – largely thanks to bubblevision. Investing should be boring but Wall Street tries to sell you sexy and exciting.

People often judge a past decision by its ultimate outcome rather than basing it on the quality of the decision at the time it was made, given what was known at that time. This is outcome bias. We must concentrate on process. Process is a set of rules that govern how we go about investing. When every decision is measured on outcomes, investors are likely to avoid uncertainty, chase noise, and herd with the consensus. Sounds like a pretty good description of the investment industry to me. Process over outcomes. Always.

(1) Bat = $1.05 & Ball = $0.05
(2) 5 minutes (one widget per machine for 5 minutes)
(3) 47 days (if it’s half covered and then doubles that means it’s fully covered the next day)

The Little Book of Behavioral Investing

Further Reading:
James Montier’s Laws of Investing



What's been said:

Discussions found on the web