Behavioural Investing

Behavioural Investing 4 – Doing Nothing, Being Contrarian, Selling and Process

by Mike Rawson · June 15, 2017

Today’s post is our fourth and final look at James Montier’s Little Book of Behavioural Investing.

Contents

Doing nothing
The Fat Pitch
Becoming contrarian
Loss aversion
Selling
The Endowment Effect
Process
Good intentions

Doing nothing

Chapter Thirteen is about the value of doing nothing.

Investors increasingly have a short-term focus.

James illustrates this with a chart showing the average holding period for a stock on the NYSE.
This is down from eight years in the 1950s to six months when James was writing the book.

This focus on just a couple of reporting periods is at odds with the drivers of equity returns.

Over a year, price changes are basically down to almost random fluctuations in the company’s PE multiple.
By five years, 80% of returns are down to the growth in the underlying cash flows, and the price you paid to start off with.

James points out that the best strategy for a football goalkeeper facing a penalty is not to dive, but to stay still and hope the ball is kicked near the centre of the goal.

Kicks are fairly evenly distributed, so by doing this they would save 33% of penalties, rather than the actual 20%.

But goalies dive 94% of the time because it makes them look like they are trying harder.

This is called the bias to action.

Unfortunately, this bias gets worse when you are losing.

In an experiment, subjects were told about two teams who lost a match.

For the next match, one coach changed his team selection and the other didn’t.
But both teams lost a second match in succession.

Subjects were asked which coach felt most regret under three scenarios:

they were told about the prior loss
they were not told about the earlier game
they were told that the teams had won rather than lost the earlier game

When the the teams had won, 90% thought that the coach making changes would feel worse.

When the teams had lost, 70% thought the coach sticking with his team would feel worse.

As a keen football fan, I have some issues with this experiment, since form is temporary.¹

Making changes to personnel, formation or tactics (which many drive personnel changes) is often a good idea after a loss, as is keeping a winning team together.

The same is not true of investment.

Even with a best practice approach, you will have periods of losses.
You should not usually change course because of them.

Next James describes the experimental asset markets used to test investor behaviour.

These consist of just one asset (a stock) and cash.

The stock pays a dividend each period.
The dividend paid depends upon the state of the world.
There are four possible states, each with a 25% probability.
The stock has no earnings, so its fair value decreases as each dividend is paid out.

The expected value (EV) over a number of periods is therefore easy to calculate.

The diagram above shows one result from an experiment.

The stock is undervalued at first, then goes way above fair value, then returns closer to fair value.
So this is a bubble forming and (partially) bursting.

The interesting part is that an additional rule for this market was that you couldn’t sell any shares you bought.

This removes the “greater fool” strategy from the equation as a bubble driver.

Beats me why anyone would pay more than fair value in this situation, but they did.

The Fat Pitch

“Waiting for the fat pitch” is a investing phrase that refers back to Warren Buffett’s 1997 letter to shareholders.

He’s talking about a baseball batter who can hit .400 (this must be good) if he waits for pitches in his best hitting spot.
If he hits the worst pitches he will score .230 (that must be bad).

Waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors – Warren Buffett

The implication is that we should wait for the good opportunities to come along.

But in fact, Buffett was explaining that he saw fewer good opportunities than in previous years, and perhaps they would never come along.

We can’t be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun – Warren Buffett

Investing should be like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas – Paul Samuelson

James says that patience is an advantage for the investor.

The private investor in particular need not be fully invested and can wait for the right opportunities to come along.
Fund managers on the other hand often have a limit to the amount of cash they can hold.

Then again, the stock market trend is upwards, and it takes a brave and talented active investor to step aside for long periods.

Holding cash is uncomfortable, but not as uncomfortable as doing something stupid – Warren Buffett

James does recommend this approach, but I have never used it myself.

I typically have a large and complicated portfolio, and bear markets don’t last very long anyway.
Plus, it’s easier to decide where to sell out of a frothy market than it is to decide where to get back into a depressed one.

All men’s miseries derive from not being able to sit in a quiet room alone – Pascal

There are some other investing situations where patience is clearly a virtue:

in value stocks, which may need a catalyst to trigger a revaluation, you don’t want to buy to early.
when you have a winning stock, you don’t want to sell too early (Let Your Winners Run).

Becoming contrarian

It is impossible to produce superior performance unless you do something different from the majority – Sir John Templeton

We all like to think that we are independent thinkers, just as we all think we are better than average at our jobs, driving and sex.

Of course we are happy to think that our family, friends and neighbours are easily influenced, or have average skills.
In reality, groupthink is a common problem.

The classic experiment involves four lines (shown below).

The task was to choose which of the three on the right matches the one on the left.

Easy, no?
But as a subject, you were in a room with seven other people (working for the experimenter, unknown to you) who have each agreed in turn that one of the “wrong” lines was a match.

Around 75% of people cave in and agree with the group on at least one round of the experiment, and overall people fall in line one-third of the time.

You only need three people to agree on the wrong thing before this effect appears.
Brain scans have shown that the C-system shuts down in these circumstances.

Non-conformity appears to trigger fear, and social exclusion causes pain.

This has implications for would-be contrarian investors, who buy the stocks that everyone else is selling and vice versa.

But contrarianism does work:

A study found that the stocks fund managers sell outperform those that they buy by 17% (11% outperformance vs 6% underperformance).

Alongside the pain of going against the crowd is what James calls “carrot of conformity”.

This is the praise group members receive for sticking to the narrative of the group.

Experiments have shown that when information is part shared across a group as a whole, and part scattered to individual members of the group, the group will discuss the shared information rather than try to piece together the more useful scattered information.

The danger of groupthink is polarization – group members end up holding more extreme views because they only hear the same thing again and again.

We can see this phenomenon at the moment in the “bubble” experience of social media (particularly on political topics).

James provides eight symptoms of groupthink:

1 – An illusion of invulnerability – excessive optimism that encourages extreme risks.
2 – Rationalization – members discount warnings and do not consider their assumptions.
3 – Inherent morality – members believe in the rightness of their cause and ignore ethical or moral consequences.
4 – Stereotyped views of out-groups – “the enemy” are simply dismissed.
5 – Pressure on dissenters.
6 – Self-censorship – doubts are not expressed.
7 – Illusion of unanimity – majority view is described as “unanimous”.
8 – “Mind guards” – gatekeepers to problematic and contradictory information.

In investment, groupthink leads to bubbles, like the dot com boom, or the housing bubble of the mid-2000s.

But just because you spot a bubble, should you get out?

Bubbles often keep going for years after they become obvious, and there will be a lot of money to be made during this period.

This is one of those questions that every investor will need to answer for themselves.

James is a committed value investor, and as such a big fan of contrarian investing.

For him, this requires three elements:

the courage to be different,
being a critical thinker, and
having the perseverance to stick to your principles.

Loss aversion

The penultimate chapter in the book is about selling.

It begins with a game where you lose $100 if you guess wrong in a coin toss.

James asks you how much you would want for a correct guess in order to play the game.
The rational answer is anything above $100, but the average answer from 600 fund managers he asked was around $200.

This is because of loss aversion.

People dislike losses more than twice as much as they like the equivalent gain.

Back in the first post in this series, we looked at the 3-question “cognitive reflection task” (CRT).

Answers on that test are inversely correlated to loss aversion.

Those who get all three questions right need only $165 to play the coin toss game.

Whereas those who only got one question right need $300.

James notes that loss aversion shows up in golf.

Putts for birdies and eagles are (a few percentage points) less successful that those for par or bogeys.
Players focus more to avoid a loss.

Loss aversion appears to be genetic, as it can be observed in monkeys, too.

Loss aversion combines with short-termism when we check the value of our portfolios too much.

The more you check, the more likely you are to see a loss.
And that makes you less likely to invest more.

So don’t check your portfolio value too often.

Apart from short-term positions (trades rather than investments), I only look once a year.

Selling

As we have seen, loss aversion is asymmetrical.

Most people prefer a sure gain to the equivalent chance of a gain (a certain £25K over a 25% chance of £100K, for example).
But they will choose to risk a 25% loss of £100K to avoid a certain loss of £25K.

We avoid risky gains, but will gamble to avoid certain losses.

This translates to the idea that many investors don’t believe a loss is really a loss until they crystallise it by selling.

This means that people hold onto losing stocks and sell their winners.

They believe that losing stocks will bounce back (over-optimism, self-attribution bias).

It’s part of the disposition effect.

We ascribe a greater value to the things we own than do people who don’t own them.

Remember everybody, Cut Your Losses and Let Your Winners Run.

Terry Odean looked at 10,000 private investor brokerage accounts and found that they held losing stocks for a median of 124 days and winning stocks for a median of 102 days.

15% of winning positions were sold, but only 9% of losing positions (1.7 times more).
Sold winners subsequently outperformed held losers by 3.4% pa.

Andrea Frazzini studied fund managers.

17.6% of winners were sold, but only 14.5% of losses (1.2 times).
The best-performing funds were those with the highest percentage of realised losses (the least loss averse).
The worst performing funds showed similar loss aversion to private investors.

Remember everybody, Cut Your Losses and Let Your Winners Run.

Stop Losses can help you with this.

The Endowment Effect

James describes a bottle of wine you bought for $15 a few years ago, which is now worth $150 at auction.

The interesting thing is that people don’t want to buy another bottle at $150, but nor do they want to sell the one that they have.
This is exactly the way I feel about my house.

This is the status quo bias, part of the endowment effect (we like what we own).

It works the same with stocks.

You might not sell a stock that is down 30% (we’ve all been there), but if someone sold it for you, you probably wouldn’t buy it back again.

The classic endowment study involves half of a group of subjects being randomly given a mug.

Then a market is formed where those with mugs can sell them to those without.
You might expect half the mugs to change hands

But it’s usually much fewer (normally 10%).

The people with mugs value them much more highly than the ones without.

To test whether the key factor is a reluctance to buy or a reluctance to sell, “choosers” are added to the experiment.

Those with mugs (sellers) are asked if they want to sell at a range of prices, and “buyers” without mugs are asked if they want to buy at that price.
Choosers can take either the mug or the money.
Choosers and sellers are effectively in the same situation, except the latter are actually holding a mug (that they have owned for a few minutes only).

Choosers’ responses are in between sellers and buyers, and closer to sellers.

They value the mug at more than buyers do, but still much less than sellers.

This helps to explain why investors get so attached to stocks they hold, and why they find it hard to cut their losses.

It’s also why I think meeting company management is a bad idea.
Though some investors have the personality to cope with this.

Many investors would rather average down on a losing stock than sell.

As a committed value investor, James thinks that sometimes this is the right thing to do.
I don’t have the personality for this, and need to put my money to work somewhere else.

Process

In the final chapter, James makes the distinction between process and outcome.

We can’t control outcomes, but we can control our process.

This means that it’s important to know whether we are right for the wrong reasons (dumb luck), or wrong despite our good process (bad break).

[Dumb luck] is the wolf in sheep’s clothing that allows for one-time success but almost always cripples any chance of sustained success – Paul DePodesta

It is perfectly possible to be “right” over a five-year view and “wrong” on a six- month view, and vice versa. Price volatility is several orders of magnitude greater than fundamental volatility – James Montier

Investors often judge decisions on their outcome, rather than their quality at the time they were made (given what was known then).

This is known as outcome bias.

When asked in experiments to rate actions by doctors, people back the doctor when the outcome is positive (the patient lived) but not when the outcome is negative (the patient died).

In investing, fund-managers with an outcome bias are likely to choose stocks which are easy to justify to their clients, rather than those with the best prospects.

James lists five problems with holding people responsible for outcomes:

1 – Focus on outcomes with a higher certainty (ambiguity aversion).
2 – Collection and use of all information (both useful and useless).
3 – Preference for compromise options.
4 – Selection of products with average features over those with mixed features (some good and some bad)
5 – Higher degree of loss aversion

[Investors] avoid uncertainty, chase noise, and herd with the consensus.

It’s better to make people accountable for the process they use.

James describes an experiment in which subjects allocate funding to marketing one of two beers.

They are told that they have previously backed the wrong horse (their beer sold less) and that now in stage two they need to allocate more funding between the two beers.

Some subjects are told they will be judged on outcomes, and others on process.

A third (control) group is told neither
Those judged on outcomes allocate 58% to the previously losing beer (sunk cost fallacy), compared to 51% for the control group.
Those judged on process allocated only 40% to the previously losing beer.