Are we too slow to change our minds when the facts change?
That’s the contention of James Montier in chapter nine of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy." All too often, he said, we get locked into perma-bear or perma-bull positions, to the detriment of our portfolios.
Can you do Bayesian?
Here is another one of those games that challenges the way we think: Imagine two large urns, each filled with millions of red and blue poker chips. Seventy percent of the chips in the first urn are red and the remaining 30% are blue. The second is exactly the opposite with 70% blue and 30% red chips.
You randomly reach into one of the urns and come out with a handful of chips, 70% of which are red and 30% which are blue. What is the percentage likelihood the chips came from the urn with mainly red chips?
Montier said most people give the answer as a figure between 70% and 80%. The correct answer, he argued, was 97%, something we could learn by applying Bayes Theorem (a formula which allows us to change probabilities as new information is added). Montier sees this as evidence that people, including investors, are too conservative.
In an investing context, he put this into the context of perma-bears and perma-bulls, neither of which are money makers. It is a result, he said, of not being able to change with the times, as stocks and markets change.
Montier’s personal experience included a bullish turn he took in late 2008. He said he had been cautious for several years but changed his belief in late 2008 and early 2009. Markets, at that time, were very cheap, but when he recommended buying, the responses included hate mail from “perma-bear” clients.
Even psychologists can be reluctant to change their beliefs. Montier cited a study of psychologists, by psychologists, in which the subjects were given a case study of a man. Then, they received additional information about him in four stages. Once again, the results showed that accuracy did not change much with additional information, but confidence in their own diagnoses almost doubled. Revealingly, as the amount of information increased, the subject psychologists became less likely to change their minds.
Staying too long at the fair
Montier had a serious and a sarcastic take on mental conservatism:
“This behavioral pitfall—hanging onto your view too long—is observed frequently in the financial world. For instance, Exhibit 9.1 shows that analysts are exceptionally good at one thing, and possibly one thing alone—telling you what has just happened.” [Exhibit 9.1 is incidental to this article and not included here]
He referred to the year 2008 as a case study in financial conservatism, as so many investors failed to see what he called a “slow-motion train wreck.” Analysts, he said, lagged reality, and only changed their beliefs when they had “irrefutable proof they were wrong” and even then were very slow to change their minds. He attributed this to “anchoring” and slow adjustment.
How slow? Montier turned again to the body of work that included the “urn” test:
“A convenient first approximation to the data would say that it takes anywhere from two to five observations to do one observation’s worth in inducing the subject to change their opinions.”
Sunk costs
Going more deeply into the reluctance to change, Montier introduced the idea of sunk costs, or the sunk-cost fallacy. This refers to an expense that has already been incurred and cannot be recovered now or in the future. It should not be a factor when new investments are made.
The author points out that we fall back into sunk-cost positions mentally as well as financially:
“Brutally put, we tend to hang onto our views too long simply because we spent time and effort in coming up with those views in the first place.”
To back this idea up, he created another test. In it, he took similar situations and differentiated them by giving one a sunk-cost context while leaving the other unchanged. Montier said this simple change had a “truly massive impact” on the results. The scenario with the sunk-cost context made the test subjects more inclined to maintain their existing beliefs. “This highlights the power of the sunk cost and its role in creating conservatism,” he said.
A remedy or four
Montier recommended we give ourselves a blank sheet of paper and analyze new buys and sells as if nothing else in the world affected our decisions.
We also might revisit our investment cases and begin analyzing them with a blank slate. Do the assumptions we made previously still hold? Did we miss anything in our original case? A tongue-in-cheek corrective to the process: Montier advocated an “analyst amnesty,” forgiving ourselves for our earlier mistakes.
Then, there are devil’s advocate sessions in which someone who sincerely disagrees with the majority position is given time and resources to break the case.
Most striking of all was the cure taken by fund manager Michael Steinhardt when he felt his portfolio was getting out of sync with the market. According to Montier, he would sometimes sell the entire portfolio at once and start over again with “a portfolio of names that represented our strongest convictions and cut us free from wishy-washy holdings.”
Conclusion
Another of the behavioral investing problems facing investors is that of being too slow to change our opinions and beliefs when the facts change. It is the central theme in chapter nine of Montier's book, "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy".
Part of the issue involves recognizing how probabilities change as new information becomes available. Montier showed us the poker chip game, based on the Bayesian Theorem, to illustrate that side of our mental make-up.
To help us understand how this phenomenon occurs, Montier posits a theory of mental sunk costs. By this he meant that once we have taken the time and effort to learn something, we are not in a hurry to replace it with something new.
To counter this, he suggests we use a blank piece of paper (figuratively speaking), give ourselves an "analyst amnesty" or start over with our portfolio (the latter being a drastic measure).
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.)
Disclosure: I do not own shares in any company named, and do not expect to buy any in the next 72 hours.
