Behavioural Investing

JAMES MONTIER is the global equity strategist at Dresdner Kleinwort in London. He has been the top rated strategist in the annual Extel survey for the last two years. He is also the author of Behavioural Finance, published by Wiley in 2000. James was on the 50 must read analysts list complied by the Business magazine, and was one of the Financial News' Rising Stars.James is a regular speaker at both academic and practitioner conferences, and is regarded as the leading authority on applying behavioural finance to investment. He is also a visiting fellow at the University of Durham. James is also a fellow of the Royal Society of Arts. He has been described as a maverick by the Sunday Times, an enfant terrible by the FAZ, and a prophet by the Fast Company! When not writing or reading, he can usually be found blowing bubbles at fish and swimming with sharks.

• Preface xviiAcknowledgments xxiSection I: Common Mistakes and Basic Biases 11 Emotion, Neuroscience and Investing: Investors as Dopamine Addicts 3Spock or McCoy? 5The Primary of Emotion 5Emotions: Body or Brain? 6Emotion: Good, Bad of Both? 7Self-Control is Like a Muscle 11Hard-Wired for the Short Term 13Hard-Wired to Herd 14Plasticity as Salvation 152 Part Man, Part Monkey 17The Biases We Face 19Bias #1: I Know Better, Because I Know More 19The Illusion of Knowledge: More Information Isn’t Better Information 20Professionals Worse than Chance! 21The Illusion of Control 22Bias #2: Big ≠ Important 23Bias #3: Show Me What I Want to See 23Bias #4: Heads was Skill, Tails was Bad Luck 24Bias #5: I Knew it all Along 25Bias #6: The Irrelevant has Value as Input 25Bias #7: I Can Make a Judgement Based on What it Looks Like 27Bias #8: That’s Not the Way I Remember it 28Bias #9: If you Tell Me it Is So, It Must be True 29Bias #10: A Loss Isn’t a Loss Until I Take It 30Conclusions 353 Take a Walk on the Wild Side 37Impact Bias 39Empathy Gaps 40Combating the Biases 444 Brain Damage, Addicts and Pigeons 475 What Do Secretaries’ Dustbins and the Da Vinci Code have in Common? 556 The Limits to Learning 63Self-Attribution Bias: Heads is Skill, Tails is Bad Luck 67Hindsight Bias: I Knew it All Along 69Skinner’s Pigeons 71Illusion of Control 72Feedback Distortion 73Conclusions 76Section II: The Professionals and the Biases 777 Behaving Badly 79The Test 81The Results 82Overoptimism 82Confirmatory Bias 83Representativeness 84The Cognitive Reflection Task (CRT) 85Anchoring 87Framing 87Loss Aversion 89Keynes’s beauty contest 90Monty Hall Problem 92Conclusions 94Section III: The Seven Sins of Fund Management 958 A Behavioural Critique 97Sin city 99Sin 1: Forecasting (Pride) 99Sin 2: The Illusion of Knowledge (Gluttony) 100Sin 3: Meeting Companies (Lust) 100Sin 4: Thinking You Can Outsmart Everyone Else (Envy) 100Sin 5: Short Time Horizons and Overtrading (Avarice) 101Sin 6: Believing Everything You Read (Sloth) 101Sin 7: Group-Based Decisions (Wrath) 101Alternative Approaches and Future Directions 102Sin 1: Forecasting (Pride) 1039 The Folly of Forecasting: Ignore all Economists, Strategists, & Analysts 105Overconfidence as a Driver of Poor Forecasting 109Overconfidence and Experts 110Why Forecast When the Evidence Shows You Can’t? 114Unskilled and Unaware 115Ego Defence Mechanism 115Why Use Forecasts? 119Debasing 12010 What Value Analysts? 123Sin 2: Illusion of Knowledge (Gluttony) 13111 The Illusion of Knowledge or Is More Information Better Information? 133Sin 3: Meeting Companies (Lust) 14112 Why Waste Your Time Listening to Company Management? 143Managers are Just as Biased as the Rest of Us 145Confirmatory Bias and Biased Assimilation 148Obedience to Authority 151Truth or Lie? 153Conclusions 157Sin 4: Thinking You Can Outsmart Everyone Else (Envy) 15913 Who’s a Pretty Boy Then? Or Beauty Contests, Rationality and Greater Fools 161Background 163The Game 163The Solution 164The Results 165A Simple Model of Our Contest 168Comparison with Other Experiments 170Learning 173Conclusions 174Sin 5: Short Time Horizons and Overtrading (Avarice) 17714 ADHD, Time Horizons and Underperformance 179Sin 6: Believing Everything You Read (Sloth) 18715 The Story is The Thing (or The Allure of Growth) 18916 Scepticism is Rare or (Descartes vs Spinoza) 197Cartesian Systems 199Spinozan Systems 199Libraries 200A Testing Structure 200The Empirical Evidence 200Strategies to Counteract Naïve Belief 203Sin 7: Group Decisions (Wrath) 20717 Are Two Heads Better Than One? 209Beating the Biases 215Section IV: Investment Process as Behavioural Defence 21718 The Tao of Investing 219Part A: the Behavioral Investor 22319 Come Out of the Closet (or, Show Me the Alpha) 225The Alpha 228The Evolution of the Mutual Fund Industry 229Characteristics of the Funds 231The Average and Aggregate Active Share 231Persistence and Performance 231Conclusions 23320 Strange Brew 235The Long Run 237Death of Indexing 238Getting the Long Run Right 238The Short Run 239Tactical Asset Allocation 239Equity Managers 240Break the Long-Only Constraint 242Add Breadth 244Not Just an Excuse for Hedge Funds 245Truly Alternative Investments 245Conclusions 24621 Contrarian or Conformist? 24722 Painting by Numbers: An Ode to Quant 259Neurosis or Psychosis? 261Brain Damage Detection 262University Admissions 263Criminal Recidivism 263Bordeaux Wine 263Purchasing Managers 264Meta-Analysis 264The Good News 267So Why Not Quant? 26823 The Perfect Value Investor 271Trait I: High Concentration In Portfolios 273Trait II: They Don’t Need to Know Everything, and Don’t Get Caught in the Noise 276Trait III: A Willingness to Hold Cash 276Trait IV: Long Time Horizons 277Trait V: An Acceptance of Bad Years 278Trait VI: Prepared to Close Funds 27824 A Blast from the Past 279The Unheeded Words of Keynes and Graham 281On the Separation of Speculation and Investment 281On the Nature of Excess Volatility 282On the Folly of Forecasting 283On the Role of Governance and Agency Problems 284On the Importance (and Pain) of Being a Contrarian 285On the Flaws of Professional Investors 286On the Limits to Arbitrage 286On the Importance of the Long Time Horizon 287On the Difficulty of Defining Value 288On the Need to Understand Price Relative to Value 288On Why Behavioural Errors don’t Cancel Out 289On Diversification 289On the Current Juncture 289On the Margin of Safety 290On Beta 291On the Dangers of Overcomplicating 291On the Use of History 29125 Why Not Value? The Behavioural Stumbling Blocks 293Knowledge ≠ Behaviour 295Loss Aversion 296Delayed Gratification and Hard-Wiring for the Short Term 297Social Pain and the Herding Habit 300Poor Stories 301Overconfidence 301Fun 303No, Honestly I Will Be Good 303Part B: the Empirical Evidence: Value in All Its Forms 30526 Bargain Hunter (or It Offers Me Protection) 307Written with Rui AntunesThe Methodology 308Does Value Work? 309The Anatomy of Value 310The Siren of Growth 311Growth Doesn’t Mean Ignoring Valuation 311The Disappointing Reality of Growth 313Analyst Accuracy? 314Value versus Growth 316Key points 317Regional Tables 318Global 318USA 320Europe 323Japan 32527 Better Value (or The Dean Was Right!) 329Written with Rui Antunes28 The Little Note that Beats the Market 337Written with Sebastian LancettiThe Methodology and the Data 339The Results 340The Little Book Works 340Value Works 341EBIT/EV Better than Simple PE 341Quality Matters for Value 341Career Defence as an Investment Strategy 342What About the Long/Short View? 343The Future for the Little Book 344Tables and Figures 345Regional Results 34529 Improving Returns Using Inside Information 355Patience is a Virtue 357Using Inside Information 357A Hedge Perspective 359Risk or Mispricing? 359Evidence for Behavioural Errors 360Evidence Against the Risk View 361European Evidence 363Conclusions 36530 Just a Little Patience: Part I 36731 Just a Little Patience: Part II 375Written with Sebastian Lancetti Value Perspective 377Growth Perspective 380Growth and Momentum 381Value for Growth Investors 382Value and Momentum 383Implications 38332 Sectors, Value and Momentum 387Value 389Momentum 389Sectors: Value or Growth 390Stocks or Sectors 39133 Sector-Relative Factors Works Best 395Written with Andrew LapthorneMethodology 398The Results 398Conclusion 40334 Cheap Countries Outperform 405Strategy by Strategy Information 409Part C: Risk, but Not as We Know It 42335 CAPM is CRAP (or, The Dead Parrot Lives!) 425A Brief History of Time 427CAPM in Practice 427Why Does CAPM Fail? 431CAPM Today and Implications 43236 Risk Managers or Risk Maniacs? 43737 Risk: Finance’s Favourite Four-Letter Word 445The Psychology of Risk 447Risk in Performance Measurement 447Risk from an Investment Perspective 448Section V: Bubbles and Behaviour 45338 The Anatomy of a Bubble 455Displacement 457Credit Creation 457Euphoria 459Critical Stage/Financial Distress 459Revulsion 46339 De-bubbling: Alpha Generation 469Bubbles in the Laboratory 471Bubbles in the Field 472Displacement: The Birth of a Boom 473Credit Creation: Nurturing the Boom 473Euphoria 476Critical Stage/Financial Distress 477Revulsion 483Applications 487Asset Allocation 487Alpha Generation 488Balance Sheets 489Earnings Quality 489Capital Expenditure 490Long-Only Funds 491Summary 49140 Running with the Devil: A Cynical Bubble 493The Main Types of Bubble 496Rational/Near Rational Bubbles 496Intrinsic Bubbles 498Fads 499Informational Bubbles 499Psychology of Bubbles 500Composite Bubbles and the De-Bubbling Process 500Experimental Evidence: Bubble Echoes 503Market Dynamics and the Investment Dangers of Near Rational Bubbles 503Conclusions 50541 Bubble Echoes: The Empirical Evidence 507Conclusions 516Section VI: Investment Myth Busters 51942 Belief Bias and the Zen Investing 521Belief Bias and the X-System 524Confidence Isn’t a Proxy for Accuracy 528Belief Bias and the Zen of Investing 52843 Dividends Do Matter 529Conclusions 54044 Dividends, Repurchases, Earnings and the Coming Slowdown 54145 Return of the Robber Barons 54946 The Purgatory of Low Returns 56347 How Important is the Cycle? 57348 Have We Really Learnt So Little? 58149 Some Random Musings on Alternative Assets 587Hedge Funds 589Commodities 590Which Index? 590Composition of Commodity Futures Returns 591The Times They are A-Changin’ 591Conclusions 595Section VII: Corporate Governance and Ethics 59750 Abu Ghraib: Lesson from Behavioural Finance and for Corporate Governance 599Fundamental Attribution Error 601Zimbardo’s Prison Experiment 602Milgram: The Man that Shocked the World 604Conditions that Turn Good People Bad 608Conclusions 60951 Doing the Right Thing or the Psychology of Ethics 611The Ethical Blindspot 613The Origins of Moral Judgements 614Examples of Bounded Ethicality and Unconscious Biases 617Implicit Attitudes (Unconscious Prejudices) 617In-Group Bias (Bias that Favours Your Own Group) 619Overclaiming Credit (Bias that Favours You) 620Conflicts of Interest (Bias that Favours Those Who Can Pay You) 621Mechanisms Driving Poor Ethical Behaviour 627Language Euphemisms 628Slippery Slope 628Errors in Perceptual Causation 628Constraints Induced by Representations of the Self 629Combating Unethical Behaviour 62952 Unintended Consequences and Choking under Pressure: The Psychology of Incentives 631Evidence from the Laboratory 635Evidence from the Field 638Child Care Centres 638Blood Donations 638Football Penalty Kicks 639Basketball Players 640Back to the Laboratory 640Who is Likely to Crack Under Pressure? 641Conclusions 643Section VIII: Happiness 64553 If It Makes You Happy 647Top 10 65354 Materialism and the Pursuit of Happiness 655Aspiration Index 657Materialism and Happiness: The Evidence 658Problems of Materialism 660What to Do? 660Why Experiences Over Possessions? 663Conclusions 665References 667Index 677

"It is quite simply the best and most comprehensive treatment of the subject to date."  (Financial Times, Monday 3rd December 2007) "The Year's most exhaustive, and often entertaining, coverage of the behavioural literature."  (Financial Times, Saturday 15th December 2007)"...one of the few 'must read' books on the topic of investing."  (The Herald - Glasgow, Saturday 2nd February 2008)"…a fantastic insight into how markets operate… [and] one of the few "must read" on the topic of investing." (The Herald, Sat 2nd February 2008)