Behavioral Investing: Small, Manageable Steps Within a Process

In the conclusion of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy," James Montier provided more suggestions that can help us rise above the inherent biases that sabotage our investing.

Summing up

But before those brief suggestions, let’s review what he wrote in previous chapters (the bullet numbers correspond to chapter numbers):

1. X-system and C-system: References to two main processing areas of the brain. X-system refers to the emotional, reactionary part of the brain that responds without much thought, while C-system refers to the thinking, logical part of the brain. The more we use the C-system, the better our investing should go. “We should do our investment research when we are in a cold, rational state — and when nothing much is happening in the markets — and then pre-commit to following our own analysis and prepared action steps,” he wrote.
2. Responding to severe bear markets: Montier took us through various psychological research findings that illustrate how humans are almost programmed to respond the wrong way to severe bear markets. To counter this inclination to panic or paralysis, he cited Jeremy Grantham (Trades, Portfolio)’s recommendation to create a battle plan for reinvestment in advance — and stick to it.
3. Watch that overconfidence: Too much optimism and confidence can hurt investment results, especially when combined with the illusion of control. All of this can lead to misguided decisions based on emotions, rather than logic, and risks we cannot manage.
4. Why do we listen to experts? Be skeptical about the experts, who may not know as much as they (or you) think. Rather than real expertise, they may have the illusion of knowledge. Advice for this chapter: Let the women in the family do the investing — they have fewer illusions.
5. Skip the predictions and forecasts: Montier provided research showing that forecasting a stock price involves four variables and getting all correct is a long shot. He had three recommendations to replace forecasting: use reverse Discounted Cash Flow (DCF) calculations; compare asset value within a competitive environment; and know where you are now.
6. A key role for checklists: Information overload can take over our thinking, as we try to know too much about a stock or we try to take in all the noise on television and in the newspapers. In any case, too much information leads to underperformance. The solution to this problem, said Montier, is to use checklists.
7. Eliminate bubblevision: This refers to the unending flow of ideas and opinions from a whole universe of facts and fallacies, including television, newspapers, blogs and commentaries. These often try to make sense of random fluctuations even when there is no meaningful explanation.
8. More objective investing: There exists a bias known as “confirmatory bias,” which leads us to give too much emphasis to evidence that confirms our existing beliefs. To counter this, Montier offered the wisdom of Julian Robertson (Trades, Portfolio) of Tiger Management and Bruce Berkowitz (Trades, Portfolio) of Fairholme Capital Management. I added the work of Thomas Macpherson who uses a process called “Getting to Zero” to challenge all the assumptions underpinning his decisions.
9. Sunk costs: It is an old and usually wise axiom that we should change our beliefs as the evidence changes, something Montier said most investors find hard to do. Mentally, we experience something similar in the concept of sunk costs. One way to push back is to begin an analysis with a blank sheet of paper, in attempts to hold back our preconceived ideas.
10. The challenge of value investing: An alluring story can be much more persuasive than evidence or facts when we make investment decisions. “Siren songs” appeal to our X-system, the brain processes that lead us to make emotional, rather than logical, decisions. Fight back by focusing on the key fundamentals and established data.
11. Predictable surprises: Some events, called black swans, can never be predicted or anticipated. But bubbles in the markets can. In fact, John Stuart Mill laid out a five-step model of booms and busts in 1867. Montier told us we should be able to identify bubbles relatively early based on that model. He added that amateurs sometimes have an advantage over professionals in avoiding bubbles altogether or in making early exits.
12. Investment diaries: Why don’t we learn from our past mistakes? According to Montier, we are misled by two psychological biases: self-attribution bias and hindsight bias. One way to get past these biases is to use an investment diary or a recording that lists what we were thinking when we made an investment decision.
13. Do nothing: Day after day, we see messages that urge us to act now, including the noise that comes with investment speculation. Yet, investors are better off if they exercise patience and discipline rather than taking action. Montier also said that the curse of the value investor is to be too early, whether buying or selling — and the remedy is learning to exercise patience.
14. Hard to be a contrarian: In the subconscious recesses of our minds, there are forces that urge us to go along with the group, rather than think for ourselves. In response, we can develop these character traits: the courage to be different, critical thinking and sticking to principles.
15. Thinking of selling: Hidden biases affect our judgement in making sell decisions, including loss aversion, myopia, the disposition effect and the endowment effect. Montier suggested that distinguishing between cigar-butt stocks and compounder stocks would be helpful in knowing when to sell.
16. Process vs. outcomes: Outcomes are important, but we cannot control them, and we cannot wish them into fruition. However, we can control the processes that lead to outcomes, and with that control we can steer ourselves toward better outcomes.

Turning back to the conclusion (which would have been chapter 17), subtitled “The Road to Hell Is Paved With Good Intentions,” we find Montier discussing psychological research on several food-related topics. Of course, he goes on to link them to investing lessons.

First, don’t try to change everything at once. One of the authors quoted in this chapter was Bruce Wansink, who recommended not trying to change more than three aspects of behavior at one time. Small, manageable steps work best in weight loss — and investing. Figure out which three biases affect you most, and then take remedial steps.

Montier said:

“The key lesson from these investors is that we must concentrate on process. Process is the set of rules that govern how we go about investing. As we have seen time and time again in this Little Book, some of the world’s greatest investors have integrated measures into the way in which they approach investment to act as a guard against mindless investing.”

Finally:

“Thinking about these issues is the first step in overcoming your own worst enemy when it comes to investment — yourself!”

About James Montier

The author is a member of the asset-allocation team at GMO, the firm founded by Jeremy Grantham (Trades, Portfolio) in 1977. He was previously co-head of global strategy at Société Générale. 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 listed and do not expect to buy any in the next 72 hours.

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