I just finished reading this marvelous book “The Little book of Bahavioral Investing” by James Montier, it is a great book on investment psychology and decision-making.
The followings are the ten best things that I learned from this book. They also tie to my current investing experience,
1. We have two different systems embedded within our minds. X-system, is essentially the emotional approach to decision making. It is actually the default option, so all information goes first to the X-system for processing. It is automatic and effortless. The second system is C-system, is a more logical way of processing information. It requires a deliberate effort to actually engage this system. It attempts to follow a dedutive, logical approach to problem solving. C-system applies fact and logic, not illusion and emotion.
Every time I make investment decision, I need to be aware that I will be better off if I suppress the X-system, and fully engage C-system.
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2. How to invest in the heat of moment: The cure for temporary paralysis is to have a battle plan for reinvestment and stick to it. Be willingness to hold cash in the absence of compelling investment opportunity, a strong sell discipline, significant hedging activity, and avoidance of resource leverage, among others.
The “battle plan for reinvestment” is a schedule of pre-commitment that acknowledges both the empathy gap we will likely encounter and also help remove the fear-induced terminal paralysis that we are likely to be suffering.
I do not have a schedule of pre-commitment in my current investing process, that is the main reason I am always clueless on what to do or not to do when stock price fluctuates. I need to learn the 3P (Prepare, Plan and Pre-commit to a strategy) in the heat of the moment. I need to create a PLAN for myself.
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3. Confirmation bias is all too common a mistake when it comes to investing. It transpires that we are twice as likely to look for information that agrees with us than we are seek out disconfirming evidence.
One investor really stands out as having tried to protect himself against the dangers of confirmation bias: Bruce Berkowitz Capital Management. Rather than looking for all the information that would support an investment, Berkowitz tries to kill the company… he even provides a list of ways in which: ” Companies die and how thay’re killed … Here are the ways you implode: you don’t generate cash, you’re over-leveraged, you play Russian Roulette, you have idiots for management, yo uhave a bad board, you ‘de-worsify’, you buy your stock too high, you lie with GAAP accounting.”
I have invested in two positions (AIG and BAC) that Berkowitz also does. Since now I know that he has ever tried to “kill these two companies” but couldn’t, I have more confidence that these two are indeed good investments – in the long run.
In addition, I should also try to do due deligence and see whether I can kill these two good ideas or not. Remember, when condition changes, my position should change. So I should keep following the business (not price) movement of these two companies.
To avoid confirmation bias, I should sit down with the people who disagree with me most. Not so that I will change our minds easily, since my minds will not be that easy to change, but rather so that I hear the opposite side of the argument. If I can’t fiund the logical flaw in the argument, I have no business holding my view as strongly as I probably do. – this fits into my view of macro-economic movement and my view of investment. Be bold to listen to the opposite view, and critisize on both sides.
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4. People sometimes prone to be over-optimism in their abilities and skills in investing. How to defend ourselves against this? We must learn to think critically and become more skeptical. We should get used to asking “Must I believe this?” rather than the far more common “Can I believe this?”. Skepticism is the chasitity of the intellect, and it is shameful to surrender to too soon or to the first comer.
I should not be over-optimism in my investment. I should always ask myself the default question: “Why shouldn’t I own BAC and AIG?” and then look at the hard facts and make the logic thinking.
Study demonstrated that a real-time investment diary can be a very real benefit to investors because it helps us true to out thoughts at the actual point in time, rather than our reassessed version of events after we know the outcomes. An investment diary is a simple but very effective method of learning from mistakes, and should form a central part of your approach to investment.
I need to have my real-time investment diary, this blog will be served to this purpose.
In addition, psychologists has often documented a “self-serving bias” whereby people are prone to act in ways that are supportive of their own interests. But, as Warren Buffett warns, “Never ask a barber if you need a haircut.”
The most recent financial crisis provides plenty of examples of self-serving bias at work, the most egregious of which is the behavior of the rating agencies. They pretty much perjured themselves in pursuit of profit. In the housing crisis, they seemed to adopt some deeply flwed quant models which even cursory reflection should have revealed were dangerous to use. But use them they did, and transformed the sub-investment grade loans into AAA rated securities.
Think about now what Moody did with the credit downgrade of 15 biggest banks, I need to be very skeptical about this. Are these downgrades justifiable, or these downgrades just come from the “market pressure” or their self-serving bias? I need to have a grain of salt in it.
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5. Why does anyone listen to Jim Cramer? Because we want people to sound confident and we love people to sound confident. And we are willing to pay more for confident (but inaccurate) advisor. Unfortunately, statistic data show that so called expert advice given are mostly suboptimal.
In addtion (and worse), the ideas that flood around the news and Internet are always two sided oppinions. So which idea we should believe?
I need to stick to my investment discipline, ignore the actions of others, and stop listening to the so-called experts.
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6. Philosopher Lao Tzu observed, “Those who have knowledge don’t predict. Those who predict don’t have knowledge.” If we can’t invest by forecasting, how should we invest? As Ben Graham pointed out” Analysis should be penetrating not prophetic.” That is to say, analysts are called anaysts, not forecasters, for a reason. All investor should devote themselves to understanding the nature of the business and its intrinsic worth, rather than wasting their time trying to guess the unknowable future.
Howard Mark says, “You can’t prdict, you can prepare.” – So I should not do economic forecasts, but do understand the status of current business cycle, and be prepared for it. I know that US economy is in the recovery phase, so I need to be prepared for it.
In addition, as recommended, I need to read Bruce Greenwald’s great book on earning power valuation.
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7. Be aware of the information overflow. Focus on the critical, fundmental information, filter out the noises, do not succumbe to the siren call of Wall Street’s many noise peddlers. This can help make better investment.
Buffet’s way to distinguish the noise from critical things, “Our method is very simply. We just try to buy business with good-to-superb underlying economics run by honest and able people and buy them at sensible prices. That’s all I’m trying to do.”
James Montier’s checklist:
- valuation: is this stock seriously undervalued?
- Balance sheet: is this stock going bust?
- Capital discipline: what is the management doing with the cash I’m giving them?
Having checklist to force people to go through the steps. And the results of the checklist implementation are astounding. – I need to apply investment checklist regularly.
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8. Both perma-bears and perma-bulls are attention-getters, not money makers. The perma-bear cult, of which I have often been accused of being a member, never ever or rarely make money. Ironically, the perma-bear crowd is typically uninhabited by the money managers.
Rather than managing money, the perma-bear crowd is typically inhabited by writers of market letters, investment strategists and economists turned strategists, all of whom have little or no skin in the game. They also make a lot of speeches during downturns for a helluva lot of money and often write editorial in the Financial Times, NY Times, and Wall Street Journal.
I need to have a grain of salt in reading all these financial news and comments.
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9. Bubbles and thir bursts aren’t black swans. They are “predictable surprises.” And they have three defining characteristics,
- At least some people are aware of the problem.
- The problem gets worse over time.
- Eventually the problem explodes into a crisis, much to the shock of most.
What prevents us from seeing these predictable surprises? At least five major psychological hurdles hamper us: over-optimism, illusion of control, self-serving bias, myopia, and inattentional blindness.
What can we do to improve this sorry state of affairs? Essentially, we must remember Harb Stein’s prosaic and prophetic word of wistom:” If something can’t go on forever, it won’t.” If markets seem too good to be true, they probably are. Learning to remember this simple fact would help prevent a great deal of the angst caused when the bubble bursts.
Normally, bubble rises and bursts in five phases: displacement, credit creation, euphoria, critical stage/financial distress, and revulsion. And there will be a prolonged nature of recovery in the wake of bubble.
So by applying the above principles to the current world: I understand what happened with the morgage crisis in US and what is happening now with europe crisis; another thought on the historical low of US interest rate (even lower than inflation), will this last? it seems too good to be true that the bond price will increase forever (interest rate will reduce further more). So is there a bubble in treasury bond? how can I take advantage of this?
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10. The need to focus on process rather than outcomes is critical in investing. The management of return is impossible, the management of risk is illusory, but process is the one thing that we can excert an influence over.
People often judge a past decision by its ultimate outcome rather than basing it on the quality of the decision at the time it was made, given what was known at that time. This is outcome bias. Psychological evidence shows that focusing on outcomes can create all sorts of unwanted actions: avoid uncertainty, chase noise, and herd with the consensus, etc.
Focusing upon process frees us up from the worrying about aspects of investment which we really can’t control- such as return. By focusing on process we maximize our potential to generate good long-term returns.
Unfortunately, focusing on process and its long-term benefits won’t necessarily help you in the short term. During periods of underperformance, the pressure always builds to change your process. Be aware to remember what Ben Grahem said, “the value approach is inherently sound … dovote yourself to that priciple. Stick to it, and don’t be led away.”
I need to learn to focus on the process than the (short-term) outcomes. Ensure to have a sound process will maximize the return in the long term.
Maybe the 11st best thing that I learned is: be patient and stay on cash if there is no good ideas. Wait for the fat pitch. And when it comes, be decisive since opportunity is rare and it won’t stay long.
