In most walks of life, humans are predisposed to action, to do something rather than nothing. But is that a good trait in the world of investing?
In chapter 13 of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy," author James Montier emphatically argued that it is not. For the chapter’s subtitle, he wrote:Â “Never Underestimate the Value of Doing Nothing.”
Myopia
Montier noted that one of the barriers preventing investors from seeing investment bubbles is myopia, or the inclination to focus on the short term. He added that average holding periods for stocks has ratcheted down over time. Specifically, the average holding period in the 1950s and '60s was seven to eight years; by the mid-2000s (before the financial crisis), the average had plunged to six months:
Montier said he had trouble reconciling such turnover with a fundamental view of investing:
“We can examine the drivers of equity returns to see what we need to understand in order to invest. At a one -year time horizon, the vast majority of your total return comes from changes in valuation—which are effectively random fluctuations in price. However, at a five-year time horizon, 80 percent of your total return is generated by the price you pay for the investment plus the growth in the underlying cash flow.”
That’s a critically important point, enough to restate it at least once: If you invest for a year, most of your return (or loss) will be from random fluctuations — which means you’re not investing at all, you’re speculating, flipping a coin. Stretch your time horizon to five years, however, and the situation reverses: The factors that influence returns are under your control. You choose whether the price is low enough and whether you stay with or leave the stock, according to the growth of its cash flow.
Sports, too
In a study of British soccer goalkeepers, the same bias toward action was found. When the attacking team gets a penalty kick on the defending team’s goal, the goalkeeper has a choice of going left, going right or staying in the center. The goalkeepers in this study dived left or right for 94% of the kicks and remained in the center just 6% of the time. That was surprising because about 60% of kicks are aimed at the center. The goalkeepers did have a rational explanation, though: In diving one way or the other, fans would know they were trying, whereas it would appear they were not trying hard enough if they simply stood in the center of the goal.
Heaping trouble upon trouble
Making matters worse is the human inclination to be even more action-oriented after a loss.
Psychologists told study participants about the coaches of two soccer teams, Steenland and Straathof. Both coaches had lost their games 4-0 the previous weekend. This Sunday, Steenland took action, bringing in three new players; Straathof did not make any changes. Again, this Sunday, both teams lost by a score of 3-0. The result? Study participants thought the coach who did not take any action would feel more regret than the coach who brought in the new players. The participant’s logic was that “if only” the coach who did nothing had done something, he might not have lost again.
Montier observed:Ă‚
“This highlights the role that counterfactual thinking plays in our judgments. When dealing with losses, the urge to reach for an action bias is exceptionally high.”
The investor bias toward action
Enter again, the investor. Montier introduced readers to the laboratory experiments subject area within economics. In this case, it involved a market with just one asset, a share, which paid a dividend once per period, and cash.
Without going into further detail, and based on trading, the asset was initially undervalued, rose to fair valuation, kept going up (“massively above fair value”) and ultimately crashed. In other words, a bubble grew and collapsed, in the same way that real bubbles emerge in real markets.
In a second version of the game, researchers had a rule that prohibited players from reselling the share — yet, players kept buying and selling it, apparently because of boredom. That, said Montier, illustrated a bias to action among investors.
The antithesis of action
Action is one side of the coin. The other is patience. Montier said, “It is required because the curse of the value investor is to be too early—both in terms of buying (known affectionately as premature accumulation) and in terms of selling. Unfortunately, in the short term being early is indistinguishable from being wrong.”
Searches for value often come up empty and, as a result, patience and discipline remain essential for value investors. If you can’t find a good investment, then do nothing at all.
Montier also referred to this as waiting for a fat pitch, analogous to the thinking of baseball hitting legend Ted Williams, who would only swing at balls entering his favorite areas of the strike zone.
Montier cited Warren Buffett (Trades, Portfolio), who put it simply:Â “Holding cash is uncomfortable, but not as uncomfortable as doing something stupid.”
The author also quoted Seth Klarman (Trades, Portfolio), who said in his book “Margin of Safety":Â
“Most institutional investors feel compelled to be fully invested at all times. They act as if an umpire were calling balls and strikes—mostly strikes—thereby forcing them to swing at almost every pitch and forego batting selectivity for frequency.”
Finally, Montier pointed out that many investors believe investing should be exciting, mainly because of “bubblevision,” yet it never should be.
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 from this book, and other important investing books, go to this page.)
