7 sins of investing

Morningstar | 16 Sep 2014

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This article first appeared on Morningstar.com.

 

Years ago, James Montier, then with Dresdner Kleinwort Wasserstein, came out with a white paper titled Seven Sins of Fund Management that looked at how behavioural finance can affect the investment process.

Though penned almost a decade ago, the advice is timeless and has not diminished in value over the years. Morningstar revisits the lessons from Montier and Wasserstein.

Sin 1: Placing forecasting at the heart of the investment process

Forecasting is an integral part of our lives. Even the weather is subject to it. But an enormous amount of evidence suggests that investors are generally hopeless at it. The core root of this inability seems to lie in the fact that we all seem to be over-optimistic and over-confident.

The answer probably lies in a trait known as anchoring, which means that in the face of uncertainty we will cling to any irrelevant number as support. So using forecasts as an integral part of the investment process is like tying one hand behind your back before you start.

Sin 2: The illusion of knowledge

This obsession with information stems from the efficient market theory: If markets are efficient then the only way they can be beaten is by knowing something that no one else does. Investors believe that to outperform they need to know more than everyone else.

Instead of focusing on a few important factors (such as valuations and earnings quality), many investors spend countless hours trying to become experts about almost everything. The evidence suggests that, in general, more information just makes us increasingly over-confident rather than better at making decisions.

We have cognitive limits to our capacity to handle information. Indeed, we seem to make the same decisions regardless of the amount of information at our disposal. Beyond pretty low amounts of information, anything we gather generally seems to increase our confidence rather than improve our accuracy.

So more information isn't better information, it is what you do with it, rather than how much you collect that matters

Sin 3: Company interactions

Why do company meetings hold such an important place in the investment process of many fund managers? The insistence of spending hours meeting company management is bizarre from a psychological standpoint.

The white paper gives at least five psychological hurdles that must be overcome if meeting companies is to add value to an investment process:

1. More information isn't better information, so why join the futile quest for an informational edge that probably doesn't exist?

2. The views of corporate managers are likely to be highly biased.

3. We all tend to suffer from confirmatory bias -- the habit of looking for information that agrees with us. So rather than ask lots of hard questions that test our base case, we tend to ask leading questions that generate the answers we want to hear.

4. We have an innate tendency to obey figures of authority. As company managers generally have reached the pinnacle of their profession, it is easy to envisage situations in which analysts and fund managers find themselves effectively awed.

5. The sad truth is that we are lousy at telling truth from deception. We all think we are great at spotting liars but generally perform in line with pure chance. So even when you meet company management, you won't be able to tell whether they are telling the truth or not.

Sin 4: Think you can outsmart everyone else

Many investors spend their time trying to "beat the gun," as Keynes put it. Keynes likened professional investment to a newspaper beauty contest in which the aim was to pick the face that the average respondent would deem to be the prettiest.

We played a version of this game with our clients to try to illustrate how hard it was to be just one step ahead of everyone else. The results illustrate just what a tall order such a strategy actually is. Only three out of 1,000 managed to pick the correct answer!

The most common behavioural traits of over-optimism and over-confidence are what lead money managers to believe they can outsmart everyone else.

Everyone thinks they can get in at the bottom and out at the top. However, this seems to be remarkably hubristic.

Sin 5: Short time horizons and over-trading

Because so many investors end up confusing noise with news and trying to outsmart each other, they end up with ridiculously short time horizons and over-trade as a consequence.

This has nothing to do with investment -- it is speculation, pure and simple. Over very short periods, the return is just a function of price changes. It has nothing to do with intrinsic value or discounted cash flow.

Sin 6: Believing everything you read

We appear to be hard-wired to accept stories at face value. Stock brokers spin stories that act like sirens drawing investors onto the rocks.

More often than not these stories hold out the hope of growth and investors find the allure of growth almost irresistible. The only snag is that all too often that growth fails to materialise.

In fact, evidence suggests that to understand something, we have to believe it first. Then, if we are lucky, we might engage in an evaluative process. Even the most ridiculous of excuses/stories is enough to get results.

We need to be sceptical of the stories we are presented with. Investors would be better served by looking at the facts, rather than getting sucked into a great (but often hollow) tale.

Sin 7: Group-based decisions

Many of the decisions taken by investors are the result of group interaction.

The generally held belief is that groups are better at making decisions than individuals. The dream model of a group is that it meets, exchanges ideas and reaches sensible conclusions. The idea seems to be that group members will offset each other's biases.

Unfortunately, social psychologists have spent most of the past 30 years showing that groups' decisions are among the worst decisions ever made. Far from offsetting biases, groups usually end up amplifying them!

Groups tend to reduce the variance of opinions and lead members to have more confidence in their decisions after group discussions (without improving accuracy).

They also tend to be very bad at uncovering hidden information. Members of groups frequently enjoy enhanced competency and credibility in the eyes of their peers if they provide information that is consistent with the group view.

So, using groups as the basis of asset allocation or stock selection seems to be yet another self-imposed handicap on performance.

This report appeared on www.morningstar.com.au 2021 Morningstar Australasia Pty Limited

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