Optimism and self-confidence are wonderful traits to possess as we make our way through life’s trials and tribulations. But James Montier argued in chapter three of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy" that those traits pose problems for investors.
Self-confidence and the illusion of control
As he started the chapter, Montier once again drew on psychological research to show readers that they are likely to be very self-confident, maybe even, in fact, too self-confident. That includes Montier’s own research:
“When I asked a sample of more than 600 professional fund managers how many of them were above-average at their jobs, an impressive 74 percent responded in the affirmative. Indeed, many of them wrote comments such as, 'I know everyone thinks they are, but I really am!' Similarly, some 70 percent of analysts think they are better than their peers at forecasting earnings—yet, the very same analysts had 91 percent of their recommendations as either buys or holds in February 2008.”
The author says our innate inclination to overrate our abilities is further amplified by the illusion of control, in the sense we think we can influence the way events turn out. He cites research showing people will pay more than four times as much for a lottery ticket if they can pick their own numbers.
From this, Montier posits that people frequently mistake randomness for control. Some of the factors that make us feel we are in control are:
- Lots of choices are available.
- Having early success at a task.
- Doing a familiar task.
- A large amount of information is available.
- You have personal involvement.
As he pointed out, those factors are much like those in the business of investing.
Optimism and emotional reactions
Montier said optimism seems to the default state of our minds, and is embedded in the X-system of processing information (the X-system is shorthand for emotional responses).
A further piece of research, discussed earlier, showed how people feeling pressured by time are more likely to turn to the X-system for answers.
Nature or nurture
On the nature side of the discussion, Montier discussed the work of Lionel Tiger, author of “Optimism: The Biology of Hope” (1979). Tiger argued people tend to avoid tasks associated with negative consequence, so humans developed a sense of optimism as they evolved over the millennia. In addition, Tiger made the case that our bodies release endorphins when injured; endorphins delivering both pain relief and feelings of euphoria. That being the case, Tiger said it made biological sense for our ancestors to experience positive emotions, which would reinforce their inclination to hunt.
At this point, Montier also cites Benjamin Graham, who said investors’ main losses came from the purchase of low-quality securities when business conditions were favorable: another example of overconfidence.
Nurture also contributes to optimism, or overoptimism. Specifically, people are inclined to act in their own interests, what’s called a “self-serving bias.”
Even auditors are susceptible to this bias. Montier pointed to a research project in which a group of auditors were given a set of financial statements, which included gray areas such as recognition of intangibles, recognition of revenue and capitalization versus expensing of expenditures.
Half of the auditors were told they were working for the company that produced the financials, while the other half were told they represented an outside investor considering a stake in the company.
It turned out that auditors who believed they were working for the company were 31% more likely to accept the company’s position in the gray areas than were the auditors who thought they were working for the investor. Ironically, Montier noted, this experiment was done in the wake of Enron’s collapse and exposure of shady auditing practices.
Bringing this home to investing, Montier said the self-serving bias routinely shows up. He argued, for example, that research by stockbrokers has three self-serving principles:
- Rule 1: The news is always fine and, if it’s not, it will get better.
- Rule 2: Everything is cheap, all the time; if not, then new valuation methodologies can be invoked.
- Rule 3: Assertion is better than evidence, which Montier said is another way of claiming a good story trumps the facts.
Awareness of these rules can help you avoid Wall Street’s self-serving bias, said the author.
Not surprisingly (this book was published in 2010), he then turned to the ratings agencies, then being criticized for their failure to recognize the dangers of subprime loans. The problems with the ratings agencies occurred, in part, because the agencies represented the organizations selling the dodgy securities. In other words, the agencies had a self-serving bias to overlook the danger:
“In the housing crisis, they seemed to adopt some deeply flawed quant models which even cursory reflection should have revealed were dangerous to use. But use them they did, and so a lot of sub-investment grade loans were suddenly transformed, as if by financial alchemy, into AAA rated securities.”
Conclusion
In chapter three of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy," Montier challenged our optimism and self-confidence in the investing arena.
He informed us we are likely to overrate our own abilities, which leads to a sense of self-control that really does not exist. And, of course, a misguided sense of control can lead us to take on risks we cannot manage.
Further, optimism is part of our emotional response when a logical response would be better for important decisions.
Both nature and nurture contribute to this optimism and overconfidence. We should be particularly aware that nurture contributes to a self-serving bias. One of the implications of this is that we should be aware of the potentially self-serving bias behind stock recommendations.
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.com profile, he was previously co-head of Global Strategy at Société Générale. The author of three book, 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.
