A review of James Montier’s Behavioural Investing, pub. by Wiley

December 12, 2010

Behavioural Investing by James Montier is a weighty book with much to tell us about an aspect of investing that has long been overlooked. Behavioral investing, of course, is basically determining why market participants do not act in a manner consistent with the fancy equations of the financial economists, as they frequently don’t. Of course, overreliance on these equations was a major contributor to the subprime crisis and the blowing up of any number of individual market participants even in good times.

Now, no one would describe his or her investing style as “behavioral,” but all fundamentals-based investing styles are ultimately behavioral in that they believe that the market is generally incapable of pricing certain companies properly. Growth investing assumes that markets underprice growth (a ridiculous view; if there’s anything markets overprice, it’s growth), and value investing assumes that markets misprice everything, but especially lack of growth. Montier himself follows a value approach, which gives his book a pleasing smugness that we value investors are accustomed to.

Much of the book contains details of psychological experiments, many of which have nothing to do with finance or markets but that reveal useful information about human psychological biases. Most important is the conclusion, borne out by experiment after experiment, that giving people more information tends to make them more confident about their conclusions but almost never more accurate. Those of us who don’t have a department full of equities researchers should be comforted by that view. Furthermore, people tend to confuse confidence with ability, which makes, say, talking to management a dangerous distraction.

He also has experiments dealing with market professionals that showed that the slightest bit of uncertainty inevitably produces bubbles. He described a game with a hypothetical “stock” that had equal probabilities of paying one of four dividends for a number of rounds, with the company being liquidated at the last dividend. Obviously, it is possible to calculate the expected value of each dividend and play the game accordingly, but he found that only graduate economics student actually played the game that way. First year business students managed to create a bubble that peaked at over 30 times the correct value, a result that was only beaten by CEOs, who created a peak at over 50 times the correct value. Think about that the next time the CEO of your favorite company announces an acquisition.

The meat of the book, though, deals with how these psychological biases and other typical market behaviors affect market performance, and in here there is much useful data to be found. He takes on the statistic that most mutual funds fail to beat the market by showing that most mutual funds have become passive indexers with a portfolio with over a hundred stocks that, coincidentally, belong to their target index. Such companies, he demonstrates, will automatically fail to beat the index by roughly the amount of their management fees, as expected. However, mutual funds that actually try to pick stocks have a tendency to earn their fees and more. He also includes an article showing that companies that are being sold by institutions do better than companies being bought by institutions, as institutions are more likely to sell companies with value characteristics like poor liquidity and low historical growth.  All of these are amply supported by historical data.

One of his interesting points is that value investing can be looked at as “time arbitrage.” I know that in a world dominated by the efficient market hypothesis, successful value investors should not exist, so one wonders if the concept of arbitrage is the only way their existence can be justified to the efficient marketeers. However, he also found that time is the friend of value investors but the enemy of growth investors. At any rate, a major behavioral bias is that market participants have no patience either for short-term losses or waiting for profits, and that people are not instinctively capable of sorting out complex cause and effect. A shabby stock that has a compelling story attached to it is much more attractive than a compelling value stock without one. Also, he found that fund managers who have done well, with three years of outperformance that has catapulted them to a better job, tend to show no outperformance afterwards, while fund managers who have been fired for incompetence tend to beat the market after they find a new job. Clearly, this is a demonstrated inability to deal with probabilities and to assume that something as complex and difficult as the markets is a deterministic process.

At any rate, the list of biases is long and difficult to categorize, since he stated in the outset that the book was written for an audience of professionals who may not have the time to sit down and follow the complicated threads of an argument through an entire book, so the chapters are brief and pretty much always self-contained essays. Of course, Charlie Munger says that he has never known anyone successful in a field that requires broad knowledge who does not read pretty much all the time, so one would expect these professionals to make time. But as behavioral investing is a broad and discursive field of study, the book probably benefits from keeping topics separate and not attempting to create a unified theory.

In all, I would say that the book is a useful guide to identifying biases that we bring to the markets and to exploit the biases of others. I should point out that many (but not all) of these mistakes can be summed up as failure to employ value investing, but that could just be a confirmation bias on my part. Montier’s Behavioural Investing would be a useful addition to any investor’s library.

One Response to “A review of James Montier’s Behavioural Investing, pub. by Wiley”

  1. This is a good book from James Montier. I have also found a good resource page from this site. http://www.eurosharelab.com/james-montier-resource-page

Leave a Reply