"The Little Book of Behavioral Investing" by James Montier is a book every investor should read at some point in their investment career. Investing psychology, or behavioral investing, is a fundamental part of being a successful long-term investor. Unfortunately, most private investors and a significant number of institutional investors fail to grasp the do's and don'ts of behavioral investing and make poor decisions driven by erratic behavior.
Within this article, I shall outline some of the concepts introduced by James Montier in his book. Hopefully, they will give you some food for thought, which might help you improve your investment process over the long term.
Don’t forecast
Trying to predict the future is impossible. Having a strategy where your wealth is tied to something which may or may not happen in the future is not sensible. Therefore, Montier recommends that investors try not to forecast a company’s outlook or earnings growth. Instead, the author suggests taking the valuation model and turning it on its head. Rather than trying to predict future sales and cash flows, take the current market price and back out what is implied for the future growth. This reduces the number of uncertainties in the calculation as you already know the current market price, which means there is one less variable to guess.
Watch out for confirmation bias
Confirmation bias can be hugely destructive, not just in the realm of investing but also for your education.
Confirmation bias is the tendency to look for the information that agrees with our line of thinking. For example, if you believe a company’s earnings have the potential to grow 20% per annum for the next 10 years, you will seek out information to support this thesis without giving any thought to possible risks and threats to this earnings growth. It is confirmation bias and a tendency to view companies with rose tinted spectacles that leads investors to take huge risks on highly speculative companies, which ultimately results in a permanent impairment of capital or total loss.
Set a target and stick to it
One way to guard against confirmation bias is to focus on your investment process.Ă‚ Analyzing the potential downside and taking a cautious approach to growth projections will help with this. Looking for a margin of safety and setting a price at which you are willing to invest is also part of this process. Psychologically, investors tend to panic and sell when the market is falling, when they should be buying. In contrast, investors will panic and buy when the market is rising, when they probably should be selling.
The best way to avoid buying and selling at the wrong times is to set predefined orders. Sir John Templeton famously kept a “wish list” of securities that he believed were well run but priced too high. He had open orders with his brokers to purchase those wish list stocks at target prices at which he considered them a bargain -- a great way to remove the psychological element from the equation.
History does not repeat itself, but it does rhyme
Trading and investing is an imprecise art. You cannot predict what is going to happen in the future. While you may know what has occurred in the past, there is no guarantee the same scenario will play out this time around.
There is no guarantee the same situation will happen twice, yet there is no harm in recording what has happened in the past to learn for the future. Keeping a trading diary is an essential part of this process. Montier believes we should keep a trading journal to cross reference our decisions and their reasons with the outcomes. An analysis of previous decisions and the results will help us understand when we are lucky and when we have used genuine skill. Most importantly, a trading diary will help us understand when we are making recurrent mistakes. George Soros (Trades, Portfolio) is another proponent of trading journals.
Conclusion
Overall, "The Little Book of Behavioral Investing" is a highly informative book for investors. The book helps readers understand their own psychological pitfalls and introduces some concepts to prevent readers from making the most common psychological trading mistakes.
The pointers above are by no means comprehensive, but they are an excellent starting point for the investor who is looking to understand more about trading psychology.
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