Behavioral finance recognizes that there are psychological reasons for all investor decisions. Most seasoned investors will tell you that finding good companies is only part of the investing discipline. The tougher aspects of investing are controlling your emotions ( greed, fear) and overcoming your biases. To get a better understanding of this subject, I decided to read another "Little Book".
I read The+Little+Book+of+Behavioral+Investing+by+James+Montier. I found it quite interesting and the various exercises and examples made it a fun exercise. Bias, emotion and overconfidence are some of the behavioral traits that can lead investors to achieve lower returns. In this Little book, James Montier makes us aware of these traits and how we can avoid some of these pitfalls. He also shows how some of the world's best investors have tackled various behavioral biases so that we can learn from their experiences.
Here are some of my takeaways.
(1) Use pre-defined orders
Sir John Templeton who was a legendary investor and mutual fund pioneer said "The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell". However, it can be difficult to take action when you find yourselves in such a situation. Mr Templeton kept a "wish list" of securities that he believed were well run but priced too high. He would have open orders with his brokers to purchase those wish list stocks at target prices at which he considered them a bargain.
(2) Don't forecast.
If you want to use discounted cash flows for your valuation, turn it upside down. Rather than trying to forecast future sales and cash flows, take the current market price and back out what is implied for the future growth. Compare this implied growth rate to your expectation or check if they are reasonable to get an idea as to the attractiveness of an idea.
(3) Create a checklist to assess your investment choices
Montier focuses on the following.
- Valuation
- Balance sheet risk
- Capital discipline of the management.
Read my previous article on using a checklist to avoid companies with an examples
(4) Guard against confirmation bias.
Confirmation bias is the tendency to look for the information that agrees with our line of thinking. So, if you like a company you will only look for positive information.
Bruce Berkowitz of Fairholme Capital Management tries to "Kill the Company". He spends a lot of time thinking about what go wrong with a company - whether its a recession, stagflation, zooming interest rates or a dirty bomb going off. He tries ways to kill the best idea. If he cannot kill it, maybe he is onto something.
(5) IPOs in general are terrible investments ( even if they have great stories) :
IPOs come to the market usually to get capital infusion for continued growth or development of products and services. The stocks offered are not usually a bargain. For every hot IPO that takes off ( like Google), you will find many times more the number that lose money for investors. Tesla anyone?
(6) 5 Phases of a bubble
Bubbles happen more often than we would like to believe. He presents a model that talks of the 5 stages of a bubble.
Displacement -> Credit creation -> Euphoria -> Critical stage/financial distress -> Revulsion.
Ofcourse, it is not easy to know where exactly we are in the bubble stage. However, selling during times of euphoria (1999 /early 2000 and then 2007) and buying during times of maximum panic and fear (Late 2008 to early 2009) would be the times for action for value investors.
(7) Maintain an investment diary
Legendary investor George Soros in his book "Alchemy of Finance" says that he kept a diary in which he recorded his thoughts that went into his investment decisions on a real-time basis. Montier says that we should cross reference our decisions and their reasons with the outcomes. Doing this will help us understand when we are lucky and we have used genuine skill and more importantly when we are making recurrent mistakes.
(8) How to be a contrarian
Value investing inherently is contrarian investing. Since value investors look for bargains and buy stocks that most other investors are selling, you need to develop a contrarian bent.
- Have the courage to be different.
- Be a critical thinker. If you are finding values that the market is not appreciating, you need to understand the reasons behind it.
- Perseverance and grit to stick to your principles.
(9) Focus on the process and not the outcomes.
Focusing on process frees us up from worrying about things we cannot control such as return.
In Ben Graham's words " The value approach is inherently sound.. devote yourself to that principle. Stick to it and don't be led astray"
