A guide to behavioural investing

7th Mar '10 by Anna Morrell

2 comments 3919 reads

We like to think of ourselves as clever, logical, rational investors. We like to think we're smart.
Unfortunately, as James Montier's recent book reminds us ^[1] , we are often driven by pride, fear, greed, shamed, or contrariness. Investors are no more rational than anyone else. In fact, our brains often work against us.

Behavioural economics looks at how people behave, and why - and shows that markets are driven by irrational impulses. We can be our own worst enemies.The good thing about this, of course, is that behavioural economics also allows us to see exactly what irrational impulses drive our investing - and once we're aware of them, we can avoid them.

Overconfidence is a common investor fault. We like to think we're better than we are, so when we make money we call it skill, and when we lose money we call it bad luck. To be a better investor, you need to assess the results of your investing strategy more scientifically - what did you get right? What did you miss out in your analysis? How can you do better in future? Be humble - for instance, believe that if a superficially attractive stock has a yield of 9.5%, there's probably something you don't know - but other people do - that means it's likely to cut the dividend.
Confirmation bias means that we're always looking for confirmation of decisions we have already made. That may mean you tend not to read articles which disagree with your investment views. It may mean you give yourself a pat on the back every time the Questor column or the Charles Stanley analyst agree with your views. Be very wary. Expose yourself deliberately to opposing views, and assess them carefully.
Loss aversion is a really major problem. Irrationally, we hang on to stocks that are losing us money until they regain the price we bought at. Remember, the price you bought at has nothing to do with the stock's value. If you lose £100, your feelings of loss are much greater than your joy when you find £100! Steeling yourself to use stop losses and look at your loss-making shares rationally can help improve your performance. Stop avoiding losses, and start making profits instead.
Spotting patterns can be a sign of the great investor. But be careful - many investors spot irrelevant patterns. 'Buy after three…

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marben100

7th Mar '10

Whilst there are several good points in the above article, which I would wholeheartedly endorse, there is also, IMO, bad advice:

Steeling yourself to use stop losses and look at your loss-making shares rationally can help improve your performance.

Later, the article says:

Use quantitative approaches such as value investing to cut out emotional, irrational responses to the data and ensure you are acting logically.

The use of stop losses is a direct contradiction of that advice. Why? Consider what triggers a stop loss: a fall in the share price. A falling share price has nothing to do with fundamental, value based investing. However, that does not mean you should ignore a falling share price. When a share price falls, you do need ask yourself the question: why? Is it because of some flaw in your analysis, have the prospects for your investment changed?

As the author recommends, you DO need to look dispassionately at viewpoints in opposition to your own and this is hard. You also need to ask yourself: have I researched this company sufficiently?Once you have done so, however, you may find that a fall in the shareprice represents an opportunity to add to your holding, rather than a reason to sell. In my own experience, I can cite several examples where I have ignored "the market" at my peril and lost money. Sometimes, large market players may have information you do not possess. However, I have also made my greatest gains (outweighing the losses by a considerable margin, over many years of investing) by doing so, and adding to positions when I was confident that the "herd view" was wrong.

Talk of "falling knives" is precisely the sort of emotive twaddle that the serious investor should ignore.

The above analysis is also a strong argument that leverage should be avoided in almost all circumstances. If you use leverage, then you MUST use stop losses which, as I've explained, are antithetical to rational investing.

Another point that is worth mentioning is the opposite case: the price of your investment rises significantly. You then have to ask, does the share still represent value, or has the market simply come round to my way of thinking? Unless the fundamentals of your investment have improved, a rise in the shareprice represents a diminution in value. Again, contrary to the popular advice, "run your winners" (which has more to do with gambling than investing), this might be a time to consider trimming your investment and redirecting your capital to better value situations. It is good discipline to identify a target "fair value" for your investment when you invest intially and reexamine your position if and when that fair value is reached.

Regards,

Mark

emptyend

Hi Mark,

you DO need to look dispassionately at viewpoints in opposition to your own and this is hard. You also need to ask yourself: have I researched this company sufficiently?Once you have done so, however, you may find that a fall in the shareprice represents an opportunity to add to your holding, rather than a reason to sell.

I have also made my greatest gains (outweighing the losses by a considerable margin, over many years of investing) by doing so, and adding to positions when I was confident that the "herd view" was wrong.

So have I, albeit probably being less active in doing this than you have been! The bottom line, though, is that there are NO easy answers to investing.......we cannot ALL outperform the market at the same time - indeed the odds are that less than half of investors will do so over any given time period (thanks to dealing costs etc)....and even that may well not be true if large investors such as hedge funds do very well at the expense of the masses.

Quite so. Emotive twaddle indeed! Having said that, of course, there must be plenty of people who recognise such stocks from the banking sector - and many of them will have lost fortunes by plunging into apparently-cheap shares far too early. There is NO substitute for actually understanding the businesses you are investing in (or actually RUNNING in the case of the banks!! ;-))

IMO anyone who uses more than occasional modest leverage (say 10% or so of the amount invested, up to about 50% of the time) is essentially gambling rather than investing. Stop losses are of course very helpful to value investors trying to build positions at times when the market is quiet and volumes are low - if stop losses can be predicted at certain levels then manipulating the price to hit stops can sometimes result in spectacular forced liquidation of leveraged long positions!

This is a point of particular interest to me in 2010, as I am sitting on several stocks where major newsflow can be expected. I got where I am today by running my winners - after buying SOCO at 30p 11 years ago (now £16) , I would certainly have sold (more than the modest amount that I have) if I'd followed other approaches. OTOH there have certainly been 2-3 periods of underperformance, some of which have been quite lengthy (notably Q3 2007- Q4 2009).......and these have had some significant opportunity costs attached to them. For the great majority of the period I've held SOCO, I have been expecting a return over the coming 12 months of 75-100%.......but of course for a large chunk of the time this has actually failed to materialise. Today is no different - the shares stand at £16 and I'm expecting to see the price roughly double over the next year.......

....though there WAS a time, back in 2007, where my "expected return" for the next year dropped to about 50% - and, in retrospect, that was a time to sell a chunk....because the stock was priced more fully than it had been (even though my expected return remained, by most standards, quite high). The other reason I should have sold in 2007 was that for only TWO days in 11 years, the stock hit my own estimation of its true value at that point in time - and like a fool I convinced myself that good news soon would quickly justify a further price rise. This of course is also a mistake I have made since...expecting "things" to happen prematurely......

....but, if one takes a sufficiently-long perspective, how much do these things really matter? Everyone gets things wrong from time to time - nobody gets it right all the time. The important thing is to get it more right than wrong over the timescale one sets oneself for investment......and if one is dealing in periods over 10+ years, then I'd suggest that a year or two ...or threee.....of underperformance is a small price to pay if the rest of the time the shares have outperformed. I have so far underperformed in 2003, 2008 and 2009.....but if, at the end of the day, my largest shareholding can produce a 100-fold return over 12 years (and it has just started its 12th year and is up about 50-fold to date) then that is the sort of return that I'd happily take time and again (if only I could find the opportunities!).

Incidentally (before anyone pipes up with the accusation), it isn't a matter of "falling in love" or some other emotional attachment to the stock concerned - it is a rational assessment of the prospects of the stock. The fact that the markets have had some prolonged periods of not recognising this is something that is irrelevant to the long-term returns and nothing to get excited about (hence I don't bother arguing the toss with those who take a different view)....ultimately the proof will be in the pudding (or so I hope!).

rgds

A guide to behavioural investing

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Anna Morrell

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