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Behavioural Investing


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Table of Contents

Preface xvii

Acknowledgments xxi

Section I: Common Mistakes and Basic Biases 1

1 Emotion, Neuroscience and Investing: Investors as Dopamine Addicts 3

Spock or McCoy? 5

The Primary of Emotion 5

Emotions: Body or Brain? 6

Emotion: Good, Bad of Both? 7

Self-Control is Like a Muscle 11

Hard-Wired for the Short Term 13

Hard-Wired to Herd 14

Plasticity as Salvation 15

2 Part Man, Part Monkey 17

The Biases We Face 19

Bias #1: I Know Better, Because I Know More 19

The Illusion of Knowledge: More Information Isn’t Better Information 20

Professionals Worse than Chance! 21

The Illusion of Control 22

Bias #2: Big ≠ Important 23

Bias #3: Show Me What I Want to See 23

Bias #4: Heads was Skill, Tails was Bad Luck 24

Bias #5: I Knew it all Along 25

Bias #6: The Irrelevant has Value as Input 25

Bias #7: I Can Make a Judgement Based on What it Looks Like 27

Bias #8: That’s Not the Way I Remember it 28

Bias #9: If you Tell Me it Is So, It Must be True 29

Bias #10: A Loss Isn’t a Loss Until I Take It 30

Conclusions 35

3 Take a Walk on the Wild Side 37

Impact Bias 39

Empathy Gaps 40

Combating the Biases 44

4 Brain Damage, Addicts and Pigeons 47

5 What Do Secretaries’ Dustbins and the Da Vinci Code have in Common? 55

6 The Limits to Learning 63

Self-Attribution Bias: Heads is Skill, Tails is Bad Luck 67

Hindsight Bias: I Knew it All Along 69

Skinner’s Pigeons 71

Illusion of Control 72

Feedback Distortion 73

Conclusions 76

Section II: The Professionals and the Biases 77

7 Behaving Badly 79

The Test 81

The Results 82

Overoptimism 82

Confirmatory Bias 83

Representativeness 84

The Cognitive Reflection Task (CRT) 85

Anchoring 87

Framing 87

Loss Aversion 89

Keynes’s beauty contest 90

Monty Hall Problem 92

Conclusions 94

Section III: The Seven Sins of Fund Management 95

8 A Behavioural Critique 97

Sin city 99

Sin 1: Forecasting (Pride) 99

Sin 2: The Illusion of Knowledge (Gluttony) 100

Sin 3: Meeting Companies (Lust) 100

Sin 4: Thinking You Can Outsmart Everyone Else (Envy) 100

Sin 5: Short Time Horizons and Overtrading (Avarice) 101

Sin 6: Believing Everything You Read (Sloth) 101

Sin 7: Group-Based Decisions (Wrath) 101

Alternative Approaches and Future Directions 102

Sin 1: Forecasting (Pride) 103

9 The Folly of Forecasting: Ignore all Economists, Strategists, & Analysts 105

Overconfidence as a Driver of Poor Forecasting 109

Overconfidence and Experts 110

Why Forecast When the Evidence Shows You Can’t? 114

Unskilled and Unaware 115

Ego Defence Mechanism 115

Why Use Forecasts? 119

Debasing 120

10 What Value Analysts? 123

Sin 2: Illusion of Knowledge (Gluttony) 131

11 The Illusion of Knowledge or Is More Information Better Information? 133

Sin 3: Meeting Companies (Lust) 141

12 Why Waste Your Time Listening to Company Management? 143

Managers are Just as Biased as the Rest of Us 145

Confirmatory Bias and Biased Assimilation 148

Obedience to Authority 151

Truth or Lie? 153

Conclusions 157

Sin 4: Thinking You Can Outsmart Everyone Else (Envy) 159

13 Who’s a Pretty Boy Then? Or Beauty Contests, Rationality and Greater Fools 161

Background 163

The Game 163

The Solution 164

The Results 165

A Simple Model of Our Contest 168

Comparison with Other Experiments 170

Learning 173

Conclusions 174

Sin 5: Short Time Horizons and Overtrading (Avarice) 177

14 ADHD, Time Horizons and Underperformance 179

Sin 6: Believing Everything You Read (Sloth) 187

15 The Story is The Thing (or The Allure of Growth) 189

16 Scepticism is Rare or (Descartes vs Spinoza) 197

Cartesian Systems 199

Spinozan Systems 199

Libraries 200

A Testing Structure 200

The Empirical Evidence 200

Strategies to Counteract Naïve Belief 203

Sin 7: Group Decisions (Wrath) 207

17 Are Two Heads Better Than One? 209

Beating the Biases 215

Section IV: Investment Process as Behavioural Defence 217

18 The Tao of Investing 219

Part A: the Behavioral Investor 223

19 Come Out of the Closet (or, Show Me the Alpha) 225

The Alpha 228

The Evolution of the Mutual Fund Industry 229

Characteristics of the Funds 231

The Average and Aggregate Active Share 231

Persistence and Performance 231

Conclusions 233

20 Strange Brew 235

The Long Run 237

Death of Indexing 238

Getting the Long Run Right 238

The Short Run 239

Tactical Asset Allocation 239

Equity Managers 240

Break the Long-Only Constraint 242

Add Breadth 244

Not Just an Excuse for Hedge Funds 245

Truly Alternative Investments 245

Conclusions 246

21 Contrarian or Conformist? 247

22 Painting by Numbers: An Ode to Quant 259

Neurosis or Psychosis? 261

Brain Damage Detection 262

University Admissions 263

Criminal Recidivism 263

Bordeaux Wine 263

Purchasing Managers 264

Meta-Analysis 264

The Good News 267

So Why Not Quant? 268

23 The Perfect Value Investor 271

Trait I: High Concentration In Portfolios 273

Trait II: They Don’t Need to Know Everything, and Don’t Get Caught in the Noise 276

Trait III: A Willingness to Hold Cash 276

Trait IV: Long Time Horizons 277

Trait V: An Acceptance of Bad Years 278

Trait VI: Prepared to Close Funds 278

24 A Blast from the Past 279

The Unheeded Words of Keynes and Graham 281

On the Separation of Speculation and Investment 281

On the Nature of Excess Volatility 282

On the Folly of Forecasting 283

On the Role of Governance and Agency Problems 284

On the Importance (and Pain) of Being a Contrarian 285

On the Flaws of Professional Investors 286

On the Limits to Arbitrage 286

On the Importance of the Long Time Horizon 287

On the Difficulty of Defining Value 288

On the Need to Understand Price Relative to Value 288

On Why Behavioural Errors don’t Cancel Out 289

On Diversification 289

On the Current Juncture 289

On the Margin of Safety 290

On Beta 291

On the Dangers of Overcomplicating 291

On the Use of History 291

25 Why Not Value? The Behavioural Stumbling Blocks 293

Knowledge ≠ Behaviour 295

Loss Aversion 296

Delayed Gratification and Hard-Wiring for the Short Term 297

Social Pain and the Herding Habit 300

Poor Stories 301

Overconfidence 301

Fun 303

No, Honestly I Will Be Good 303

Part B: the Empirical Evidence: Value in All Its Forms 305

26 Bargain Hunter (or It Offers Me Protection) 307
Written with Rui Antunes

The Methodology 308

Does Value Work? 309

The Anatomy of Value 310

The Siren of Growth 311

Growth Doesn’t Mean Ignoring Valuation 311

The Disappointing Reality of Growth 313

Analyst Accuracy? 314

Value versus Growth 316

Key points 317

Regional Tables 318

Global 318

USA 320

Europe 323

Japan 325

27 Better Value (or The Dean Was Right!) 329
Written with Rui Antunes

28 The Little Note that Beats the Market 337
Written with Sebastian Lancetti

The Methodology and the Data 339

The Results 340

The Little Book Works 340

Value Works 341

EBIT/EV Better than Simple PE 341

Quality Matters for Value 341

Career Defence as an Investment Strategy 342

What About the Long/Short View? 343

The Future for the Little Book 344

Tables and Figures 345

Regional Results 345

29 Improving Returns Using Inside Information 355

Patience is a Virtue 357

Using Inside Information 357

A Hedge Perspective 359

Risk or Mispricing? 359

Evidence for Behavioural Errors 360

Evidence Against the Risk View 361

European Evidence 363

Conclusions 365

30 Just a Little Patience: Part I 367

31 Just a Little Patience: Part II 375
Written with Sebastian Lancetti

Value Perspective 377

Growth Perspective 380

Growth and Momentum 381

Value for Growth Investors 382

Value and Momentum 383

Implications 383

32 Sectors, Value and Momentum 387

Value 389

Momentum 389

Sectors: Value or Growth 390

Stocks or Sectors 391

33 Sector-Relative Factors Works Best 395
Written with Andrew Lapthorne

Methodology 398

The Results 398

Conclusion 403

34 Cheap Countries Outperform 405

Strategy by Strategy Information 409

Part C: Risk, but Not as We Know It 423

35 CAPM is CRAP (or, The Dead Parrot Lives!) 425

A Brief History of Time 427

CAPM in Practice 427

Why Does CAPM Fail? 431

CAPM Today and Implications 432

36 Risk Managers or Risk Maniacs? 437

37 Risk: Finance’s Favourite Four-Letter Word 445

The Psychology of Risk 447

Risk in Performance Measurement 447

Risk from an Investment Perspective 448

Section V: Bubbles and Behaviour 453

38 The Anatomy of a Bubble 455

Displacement 457

Credit Creation 457

Euphoria 459

Critical Stage/Financial Distress 459

Revulsion 463

39 De-bubbling: Alpha Generation 469

Bubbles in the Laboratory 471

Bubbles in the Field 472

Displacement: The Birth of a Boom 473

Credit Creation: Nurturing the Boom 473

Euphoria 476

Critical Stage/Financial Distress 477

Revulsion 483

Applications 487

Asset Allocation 487

Alpha Generation 488

Balance Sheets 489

Earnings Quality 489

Capital Expenditure 490

Long-Only Funds 491

Summary 491

40 Running with the Devil: A Cynical Bubble 493

The Main Types of Bubble 496

Rational/Near Rational Bubbles 496

Intrinsic Bubbles 498

Fads 499

Informational Bubbles 499

Psychology of Bubbles 500

Composite Bubbles and the De-Bubbling Process 500

Experimental Evidence: Bubble Echoes 503

Market Dynamics and the Investment Dangers of Near Rational Bubbles 503

Conclusions 505

41 Bubble Echoes: The Empirical Evidence 507

Conclusions 516

Section VI: Investment Myth Busters 519

42 Belief Bias and the Zen Investing 521

Belief Bias and the X-System 524

Confidence Isn’t a Proxy for Accuracy 528

Belief Bias and the Zen of Investing 528

43 Dividends Do Matter 529

Conclusions 540

44 Dividends, Repurchases, Earnings and the Coming Slowdown 541

45 Return of the Robber Barons 549

46 The Purgatory of Low Returns 563

47 How Important is the Cycle? 573

48 Have We Really Learnt So Little? 581

49 Some Random Musings on Alternative Assets 587

Hedge Funds 589

Commodities 590

Which Index? 590

Composition of Commodity Futures Returns 591

The Times They are A-Changin’ 591

Conclusions 595

Section VII: Corporate Governance and Ethics 597

50 Abu Ghraib: Lesson from Behavioural Finance and for Corporate Governance 599

Fundamental Attribution Error 601

Zimbardo’s Prison Experiment 602

Milgram: The Man that Shocked the World 604

Conditions that Turn Good People Bad 608

Conclusions 609

51 Doing the Right Thing or the Psychology of Ethics 611

The Ethical Blindspot 613

The Origins of Moral Judgements 614

Examples of Bounded Ethicality and Unconscious Biases 617

Implicit Attitudes (Unconscious Prejudices) 617

In-Group Bias (Bias that Favours Your Own Group) 619

Overclaiming Credit (Bias that Favours You) 620

Conflicts of Interest (Bias that Favours Those Who Can Pay You) 621

Mechanisms Driving Poor Ethical Behaviour 627

Language Euphemisms 628

Slippery Slope 628

Errors in Perceptual Causation 628

Constraints Induced by Representations of the Self 629

Combating Unethical Behaviour 629

52 Unintended Consequences and Choking under Pressure: The Psychology of Incentives 631

Evidence from the Laboratory 635

Evidence from the Field 638

Child Care Centres 638

Blood Donations 638

Football Penalty Kicks 639

Basketball Players 640

Back to the Laboratory 640

Who is Likely to Crack Under Pressure? 641

Conclusions 643

Section VIII: Happiness 645

53 If It Makes You Happy 647

Top 10 653

54 Materialism and the Pursuit of Happiness 655

Aspiration Index 657

Materialism and Happiness: The Evidence 658

Problems of Materialism 660

What to Do? 660

Why Experiences Over Possessions? 663

Conclusions 665

References 667

Index 677

About the Author

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.


"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)

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