Of the many ways we can be seduced into making bad decisions, one of the most subversive is the alluring story. As investors, we’re quite likely to succumb to such stories.
In chapter 10 of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy," James Montier discussed what he calls the “siren song of stories.” Put bluntly, he said:
“Stories essentially govern the way we think. We will abandon evidence in favor of a good story.”
Surprising stories
He gave examples of this from legal and medical contexts. Regarding the first, researchers used mock trials to test the influence of stories in swaying the opinions of jurors. In one test, the prosecution could tell a story to supplement the evidence while the defense could not. In the second case, the situation was reversed. Regardless of which side used the story plus evidence, it was far more likely to get the verdict it wanted.
“This clearly demonstrates the power that stories have over us: a near 50 percentage point swing in the number of people saying someone is guilty of first degree murder based on whether a story was told or not.”
Similar results were obtained among medical patients when given positive stories and negative stories. All participants were told a treatment was 90% effective, but half were given positive stories and half were given negative stories. Again, both groups were told the treatment was 90% effective. Yet 88% of the group given the positive story opted for treatment while only 39% of the group given the negative story chose to be treated.
Value stock stories
At this point in the book, Montier asked a provocative question:
“Could something similar be at work in the stock market? It is possible that investors shun value stocks because of their poor stories and low prices. As Joel Greenblatt (Trades, Portfolio) has observed, one of the reasons people shy away from value investing is that the stocks you consider have poor stories. As he puts it 'The companies that show up on the screens can be scary and not doing so well, so people find them difficult to buy.'”
He also tried to answer the question by looking at psychological research. In an experiment, researchers picked a group of “admired” companies that had averaged sales growth of 10% per year; they also picked a “despised” list made up of stocks with average sales growth of just 3.5%. Montier said the stocks that were admired had great stories and high prices, while the despised had “terrible” stories and low valuations.
From a value investing perspective, stocks on the despised list enjoy much brighter prospects, but most investors would opt for the admired companies with their great stories and high valuations. Montier added:
“Yet, the despised stocks are generally a far better investment. They significantly outperform the market as well as the admired stocks.”
There is a third group of stocks Montier wanted to discuss in this context: initial public offerings. He reported on a study showing they underperformed the market in the three years after their listings by 21%. Yet they are very popular, and sometimes have oversubscriptions or lineups to buy:
“Despite the fact that long-term IPO underperformance is a very well documented fact, investors keep stepping up to the plate and purchasing IPOs. I suspect this is because the stories overwhelm the evidence, just as occurred in the medical study outlined above.”
The capitalization of hope
In saying that investors overpay for the hope of growth, Montier turned to Benjamin Graham, who called it, “The capitalization of entirely conjectural future prospects.”
To provide an example, he turned to China and the mining sector between the years of 2003 and 2008. Many stories predicted an ever-increasing appetite for metals such as iron ore, steel and copper, and often referred to the China Effect.
As growth continued, analysts became ever more bullish, and some even predicted 12.5% annual growth for the foreseeable future. But, of course, that did not happen. Montier noted, “The straight line extrapolation of growth forecasts is a classic sign of trouble ahead in real time.”
Bring back the facts
Stories, said Montier, have emotional content, and thus they appeal to our X-systems (the emotional) as opposed to our C-systems, which appeal to our logical thinking. Focusing on the facts is the way to go, but facts are “emotionally cold” and thus not appealing to investors.
But focus on them, we must. Indeed, it may be easier to pursue just the facts than it would be to try to follow any story; after all, every story begets another story and where will you stop?
Just the facts include such data points as earnings, assets, dividends and cash flow. In addition, all are nuggets in plain sight; it’s just a matter of picking them up and determining what they tell us.
Conclusion
In chapter 10 of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy," Montier alerted us to the danger of siren stories, stories that can and do lead us astray. The effect of stories reaches into the realm of investing, as well as almost every other facet of life.
The danger of stories lies in their capacity to lead us away from the facts and evidence. Montier gave us research findings (stories in themselves) that showed how jurors and patients were overly influenced by stories, leading them to bad or potentially bad decisions.
With that, Montier went on to ask if value investing is hard because of stories. Hot stocks with good stories and dubious facts will always get more attention from the market than despicable stocks with sad stories and strong facts.
The solution, of course, is to use facts rather than stories in making our decisions. Facts such as the fundamental metrics and balance sheet numbers.
About Montier
The author is a member of the asset allocation team at GMO, the firm founded by Jeremy Grantham (Trades, Portfolio) in 1977. According to his Amazon profile, he was previously co-head of global strategy at Société Générale (XPAR:GLE, Financial). The author of three books, he is also a visiting fellow at the University of Durham and a fellow of the Royal Society of Arts. The book we are discussing was published in 2010.
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
