Investment strategist and author James Montier has something to say to investors: you may be your own enemy!
In his book ‘The Little Book of Behavioral Investing‘, Montier talks about behavioural finance and highlights psychological pitfalls that we tend to make on our investment journey.
Here are 4 biases that hinder us from being successful investors:
(I) The “Expert” Bias – be wary!
According to Montier, one of the most supported findings in psychology is that experts are generally even more overconfident than the rest of us. In fact, when being asked to make predictions, weathermen were found to be right half the time when they think they were right half the time, while doctors were only correct 15% of the time when they think they were right 90% of the time.
As humans, we tend to gravitate to the opinions of experts, and this makes us feel assured due to our bias to confidence (from experts). Montier writes that neuroscientists actually discovered that the advice from experts actually lowered brain processes that is correlated with valuation and probability weighting – reducing the ability of sound financial decision-making of subjects tested.
This has serious implications on our decisions that we make in our daily lives. When it comes to the investment world, be wary of expert opinion!
(II) The “Narrative” Fallacy
Nassim Taleb describes the narrative fallacy as the one “associated with our vulnerability to over-interpretation and our predilection for compact stories over raw truths. It severely distorts our mental representation of the world.” Montier explains that even the story of price can affect us:
“Let’s imagine you are given some wine to taste and told it costs $10 a bottle, and then some more wine and told that this second one costs $90 a bottle. Most people who found themselves in this enviable position said the $90 wine tasted nearly twice as good as the $10 wine. The only snag is that the $10 wine and the $90 wine were exactly the same wine! People were simply misled by the price.”
To guard against the narrative fallacy, Montier says we must focus on the facts. Stories usually have an emotional content, so focusing solely on the facts will help us to rely more on our logical faculties.
(III) The Conformity Bias
In the investment world, Montier says that “a willingness to subjugate one’s own thoughts for those of a group is a sadly common behavioral affliction.” The results of many psychological tests and studies have revealed that people’s ability to maintain their independence declines in the face of pressure. In fact, neuroscientists actually discovered in their observations that people who actually went with the consensus answer within a group discussion tend to show a decrease of brain activity associated with logical processing.
In the financial markets, it is no different. Legendary investor Sir John Templeton once mentioned that “it is impossible to produce superior performance unless you do something different from the majority.” This implies that in order to be more successful than others, one has to be able to diverge from the general crowd. And this is where the conformity bias will hinder us.
Montier says that there are 3 courses of action can help in fighting the conformity bias. The first is to have the courage to be different. The second is to be a critical thinker, and the third is to have perseverance and grit to stick to one’s principles.
(IV) The Endowment Effect
“Imagine you had a bottle of wine for $15 a few years ago. The wine has now appreciated vastly in price so that at auction a bottle would not fetch something north of $150. Would you be prepared to buy a bottle or sell your existing stock? The most frequently encountered answer is a resounding “no” to both questions. When faced with this situation, people are generally unwilling to either buy or sell the wine.
Let’s try another case. Imagine you own a stock that has lost 30% of its value in the last three months. Given what we know about loss aversion, the chances are you will stick with it. However, imagine you go and make a cup of tea, and while you are standing over the kettle your four year old nephew starts randomly pressing buttons on your PC looking for his favorite Thomas the Tank Engine game. You come back to your desk to find your nephew has somehow inadvertently sold your entire position. What do you do? Will you buy the shares you were previously reluctant to sell? When asked this question almost no one wants to buy back the stock.”
The endowment effect means that once you own something you start to place a higher value on it than others would. Montier says that we need to put in place processes that allow us to constantly objectively evaluate our views on the positions that we have, in order to guard against the endowment effect. “You gotta know when to hold, when to fold, when to run.”
Check out his book for more!