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The Little Book of Behavioral

Investing by James Montier

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James Montier writes about the many ways

investors are their own worst enemies. The
book concentrates on the many repeated
behavioral mistakes investors in ict on
themselves that negatively impact returns in the
process.

The Notes
Before you get started…we all think the
behavioral biases discussed below don’t apply to us.
Also, we’re better at recognizing these biases in others than ourselves —
bias blind spot.
Also, All of these biases can be found outside of investing too — diet,
exercise, shopping, and other habits.
Most of our decision-making process is hardwired, having been built
around survival over the past 100,000 years. It’s generally useful. Also, it
tends to con ict with investing.
Montier breaks decision making into two systems: the X-system is the
default, quick, emotional responses or the mental shortcuts. The C-
System is the slow, logical, deliberate, deductive responses.
Most of us believe we run on the C-System.
Most of us really rely heavily on the X-System. Because it still works
often enough, we trust it more often than we should. Especially for
investing.
There’s a three-question test to see how well we override the X-System:
1. A bat and a ball together cost $1.10 in total. The bat costs a dollar
more than the ball. How much does the ball cost?
2. If it takes ve minutes for ve machines to make ve widgets, how
long would it take 100 machines to make 100 widgets?
3. In a lake, there is a patch of lily pads. Every day the patch doubles
in size. If it takes 48 days for the patch to cover the entire lake, how
long will it take to cover half the lake?

Answers: 1.  $0.05,  2.  5 minutes,  3.  47 days (Highlight the blank space
for the answers.)
In the original study behind the test, only 17% got all three questions
right and 33% got none right. In a group of professional investors, 40%
got all three right and 10% got none right.
And if you got all three questions right and think HOME
you’re impervious
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biases, you’re not — overoptimism, overcon dence, and con rmation
bias are not immune from the test.
What does the test prove? We’re good at leaping to the rst conclusion
rather thinking things through. It works great if we’re trying to survive
being mauled by an animal, but works terribly if we’re trying to survive
in the stock market.
The best defense against your biases is “to ingrain better behavior into
your investment approach.”
Empathy Gaps — The “inability to predict our own future behavior
under emotional strain.” In other words, we have a hard time predicting
how we’ll act during some future stressful event. We overestimate
our intellectual abilities and underestimate our emotional drive.
Example #1: How we think we’ll act during the next market crash versus
how we really act during the next market crash. It’s easy to think we’ll
buy stocks during the next crash, especially when we think it while
markets are calm.
Example #2: Our inability to factor procrastination into a project. The
solution is to impose deadlines.
Investors can prevent empathy gaps by planning ahead.
Montier o ers up the seven P’s: Perfect Planning and Preparation
Prevent Piss Poor Performance.
If you want to be able to buy the market when everyone is feverishly
selling and not fall prey to similar emotional decisions, then have a plan
of attack set up in advance that forces the action. Sir John Templeton
used to set a wishlist of great companies he wanted to buy if they were
only cheaper. He’d place standing buy orders at reduced prices to force
purchases when emotions are normally running high.
“Fear causes people to ignore bargains when they are available in the
market, especially if they have previously su ered a loss.”
Jeremy Grantham: “There is only one cure for terminal paralysis: you
absolutely must have a battle plan for reinvestment and stick to it. Since
every action must overcome paralysis, what I recommend is a few large
steps, not many small ones. A single giant step at the low would be nice,
but without holding a signed contract with the devil, several big moves
would be safer. It is particularly important to have a clear de nition of
what it will take for you to be fully invested.”
Over-Optimism Bias — we tend to be optimistic by nature. we have a
positive bias, believing good results will happen more often than bad
results.
The Illusion of Control — we think we can in uence the outcome and
often mistake randomness for control. Also, the illusion of control
enhances our optimistic tendencies.
“In fact, the illusion of control seems most likely to occur when lots of
choices are available; when you have early success at the task (as per
the coin tossing); the task you are undertaking is familiar to you; the
amount of information is high; and you have a personal involvement. To
me, these sound awfully like the conditions we encounter when
investing.”
Self-Serving Bias — we tend to act in our best interests.
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“What can we do to defend ourselves against over-optimism? We must LIBRARY TOOLS

learn to think critically and become more skeptical. We should get used
to asking ‘Must I believe this?’ rather than the far more common ‘Can I
believe this?'”
Default question for investors: “Why should I own this investment?”
Overcon dence Bias — we tend to be more con dent in our own
abilities. We believe we’re above average (drivers, lovers, workers,
investors, predictors of the future) even though we can’t all be above
average.
Also, we often confuse con dence in ourselves and others for skill. We
prefer people who sound con dent even when they’re wrong. And
worse, we tend to believe the more con dent experts, and do so
without any level of skepticism.
Over-optimism and overcon dence in investing leads to more trading,
higher turnover, and underperformance. Also, men are worse than
women. Simply, it leads to a belief that we’re not only smarter than
everyone else but we can get in and out of the market faster than
everyone else.
Of course, we can’t all be smarter than everyone else. What we can be is
more disciplined than the overcon dent, over-optimist investors.
Guessing the future is hard. Overcon dence doesn’t help. All the
evidence points to it being practically impossible without luck.
But if you want to try, you have to get the forecast right, then you have
correctly guess how the market will react, and nally, you have to guess
which investment vehicle will pro t the most … even still, the only way
you’ll beat the market is if it’s di erent from the consensus view.
Forecasts are demand driven by investors who somehow believe it’s
useful (like in con rming their beliefs or o ering an illusion of certainty
or as an anchor to base decisions around).
“So, if we can’t invest by forecasting, how should we invest? As Ben
Graham pointed out “Analysis should be penetrating not prophetic.”
That is to say, analysts are called analysts, not forecasters, for a reason.
All investors should devote themselves to understanding the nature of
the business and its intrinsic worth, rather than wasting their time trying
to guess the unknowable future. Di erent investors have approached
the problem of forecasting in di erent ways. If you are wedded to the
use of discounted cash ow valuations, then you may well bene t from
turning the process on its head. Rather than trying to forecast the
future, why not take the current market price and back out what it
implies for future growth. This implied growth can then be matched
against a distribution of the growth rates that all rms have managed to
achieve over time. If you nd yourself with a rm that is at the very
limits of what previous rms have achieved, then you should think very
carefully about your purchase.”
Or as Howard Marks says: “In my opinion, the key to dealing with the
future lies in knowing where you are, even if you can’t know precisely
where you’re going.”
The Illusion of Knowledge — confusing a surface understanding of
something with a deep knowledge of it.
Signal vs Noise — not a bias, but is made worse by biases. Being
incapable of separating what’s useful (signal) from the useless
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leads to mistakes. And we tend to overweight some info, underweight
other info, and completely ignore others. So more information doesn’t
necessarily produce better results. Studies show more information does
not make us more accurate, just overcon dent on our accuracy.
Checklists can help lter the noise from the few pieces of information or
factors that really matter.
 “Jean-Marie Eveillard of First Eagle a rms my contention by saying, “It’s
very common to drown in the details or be attracted to complexity, but
what’s most important to me is to know what three, four, or ve major
characteristics of the business really matter. I see my job primarily as
asking the right questions and focusing the analysis in order to make a
decision.””
Day to day market uctuations is mostly random. That doesn’t stop
everyone from trying to give meaning to the movements.
“When it comes to the vagaries of the ups and downs of nancial
markets, Larry Summers provides us with the outside view. He co-
authored a paper in 1989 that explored the 50 largest moves in the U.S.
stock market between 1947 and 1987. Summers and colleagues
scoured the press to see if they could nd any reason for the market
moves. They concluded “On most of the sizable return days…the
information that the press cites as the cause of the market move is not
particularly important. Press reports on adjacent days also fail to reveal
any convincing accounts of why future pro ts or discount rates might
have changed.” To put it another way, more than half of the largest
moves in markets are totally unrelated to anything that might be
classed as fundamentals.”
The ctional stories might o er some certainty for the randomness of
markets but its all nonsense. It’s better to just tune out the noise.
Con rmation Bias — we are more likely to look for information that
agrees with our conclusions, beliefs, and decisions than disagrees.
Sometimes we discount discon rming evidence as “wrong,” sometimes
we’re willfully blind to it, and sometimes we twist it to support our
conclusions.
“Time and again, psychologists have found that con dence and biased
assimilation perform a strange tango. It appears the more sure people
were that they had the correct view, the more they distorted new
evidence to suit their existing preference, which in turn made them
even more con dent.”
Falsi cation — the process of trying to prove something wrong.
The solution: We need to go out of our way to prove ourselves wrong.
Learn the opposing view. Ask, “What are all the ways it could go wrong?”
Conservatism Bias — we’re slow to change our minds when new
information arrives.
Sunk Cost Fallacy — the tendency to allow past costs (like time, money,
emotion, or e ort) to a ect current decisions.
Anchoring, con rmation bias, overcon dence, and the sunk cost fallacy
are reasons why we’re slow to change our minds.
“The classic study on conservatism…concludes its analysis by saying: “A
convenient rst approximation to the data wouldHOME
say that it takes
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anywhere from two to ve observations to do one observation’s worth
in inducing the subject to change their opinions.” In other words, people
underreact to things that should make them change their minds…I
should also point out that it appears that people are particularly bad at
spotting regime changes. Researchers have shown that in a series of
experiments using urns…people tend to underreact in unstable
environments with precise signals (turning points), but overreact to
stable environments with noisy signals (trending markets). This helps
explain why economists and analysts tend to miss turning points in the
market. They get hung up on the stable environment and overreact to it;
hence they miss the important things that happen when the
environment becomes more unstable (a recession starts) and
underreact to such developments.”
Narrative Fallacy — giving meaning to a sequence of random events or
facts by weaving a story that forces a link of cause and e ect rather
than judging each individual event or fact on its own merits.
Nassim Taleb describes it like this: “The fallacy is associated with our
vulnerability to over-interpretation and our predilection for compact
stories over raw truths. It severely distorts our mental representation of
the world.”
Stories are in constant supply in the stock market. Every stock covered
in the media is given a story. IPOs literally go on a roadshow to spread
their story. Then there are story stocks, which trade not on
fundamentals, but hope and promise of future potential. All these
stories a ect our views. Almost all have an emotional pull to it.
“The most-admired companies tend to be those that have done well in
the past, in both stock market and nancial performance. They also
tend to be relatively expensive. For instance, the average sales growth
for a company in the most-admired list is 10 percent per year over the
last two years. In contrast, the despised stocks seem to have been
disasters, with an average sales growth of just 3.5 percent. Thus the
admired stocks have great stories and high prices attached to them,
whereas the despised stocks have terrible stories and sport low
valuations. Which would you rather own? Psychologically, we know you
will feel attracted to the admired stocks. Yet, the despised stocks are
generally a far better investment. They signi cantly outperform the
market as well as the admired stocks.”
The solution: Always stick to the facts.
“Ben Graham insisted that “safety must be based on study and
standards, ” and that valuations be “justi ed by the facts, e.g., the
assets, earnings, dividends, de nite prospects, as distinct, let us say,
from market quotations established by arti cial manipulation or
distorted by psychological excesses.” These wise words ring as true
today as when Graham wrote them way back in 1934, but very few
investors seem capable of heeding them. Focusing on the cold hard
facts (soundly based in real numbers) is likely to be our best defense
against the siren song of stories.”
Predictable Surprises — like bubbles, predictable surprises may be
seen but the timing of them is always uncertain. Example: Several
people recognized the housing bubble in advance but no one knew
when it would burst. HOME ABOUT LIBRARY TOOLS
Myopia — extreme focus on the short term.
Inattentional Blindness — being blind to the obvious because we’re
focused on something else.
Over-optimism, the illusion of control, self-serving bias, myopia, and
inattentional blindness help prevent us from seeing bubbles.
The solution: know that bubbles won’t last forever. All eventually burst.
Also, bubbles tend to follow a similar pattern described by John Stuart
Mill: Displacement –> Credit Creation –> Euphoria –> Financial Distress
(Critical Stage) –> Revulsion
Displacement — the start created by some opportunity or innovation in
a sector of the market. New investment in the area germinates
con dence slowly.
Credit Creation — new credit (new money i.e. new share issuance) feeds
the ames, feeds growth, con dence, and higher prices.
Euphoria — Prices can only go up is the story. New valuation metrics are
created to replace the old and justify higher prices. Over-optimism and
overcon dence abound. Speculation runs rampant. “This time is
di erent!” is the word on the street.
Financial Distress (Critical Stage) — The weight of excessive leverage
shows signs of cracking, fraud is found, insiders sell, prices fall, and
margin loans are called.
Revulsion — Panic ensues, investors would rather sell at any price than
own it. The worst cases are scarred for life.
(Long term) Individual investors have an advantage over professionals
when it comes to investing in bubbles (and in general). They’re not
beholden to a benchmark or strategy or career risk or redemptions. And
they don’t have to broadcast their holdings to anyone. They only have to
manage their behavior.
“Investors should remember bubbles are a by-product of human
behavior, and human behavior is all too predictable. The details of each
bubble are subtly di erent, but the general patterns remain eerily
similar. As such, bubbles and their bursts are clearly not black swans. Of
course, the timing of the eventual bursting of the bubble remains as
uncertain as ever, but the patterns of the events themselves are all too
predictable. As Jean Marie Eveillard observed, “Sometimes, what
matters is not so much how low the odds are that circumstances would
turn negative, what matters more is what the consequences would be if
that happens.” In other words, sometimes the potentially long-term
negative outcomes are so severe that investors simply can’t a ord to
ignore them, even in the short term.”
Of course, bubbles continue to repeat because we fail to learn from
past mistakes.
Jeremy Grantham on learning from the nancial crisis: “We will learn an
enormous amount in the very short term, quite a bit in the medium
term, and absolutely nothing in the long term. That would be the
historical precedent.”
The reason we fail to learn from our mistakes is that…we don’t see them
as mistakes.
Self-Attribution Bias — we see success due to skill and failure due to
bad luck, out of our control, or blame it on someone
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Hindsight Bias — the knew-it-all-along-e ect. After knowing the

outcome, we believe it was more easily predictable than it was at the
time.
The solution: keeping a record of the reasons behind investment
decisions and track the outcomes — skill (right for the right reasons),
good luck (right for the wrong reasons), bad luck (wrong for the right
reasons), mistakes (wrong for the wrong reasons). It holds us
accountable for our original views before the outcome.
“At a one-year time horizon, the vast majority of your total return comes
from changes in valuation—which are e ectively random uctuations in
price. However, at a ve-year time horizon, 80 percent of your total
return is generated by the price you pay for the investment plus the
growth in the underlying cash ow. These are the aspects of investment
that fundamental investors should understand, and they clearly only
matter in the long term.”
John Maynard Keynes: “Human nature desires quick results, there is a
peculiar zest in making money quickly…compared with their
predecessors, modern investors concentrate too much on annual,
quarterly and even monthly valuations of what they hold, and on capital
appreciation.”
Action Bias — the need to do something instead of nothing.
A study of soccer goalies was taken around penalty kicks. 94% of the
time, the goalie’s dove left or right to block the kick. Had they stood in
the center — done nothing — they would have blocked 60% of the kicks.
They dove because they wanted to be seen making an e ort and would
have felt worse had they done nothing and missed.
Myopia is not limited to bubbles. We love quick results. It’s why get-rich-
quick schemes never go out of style. Also, we have a bias toward action
and the urge to act is higher after a loss.
The solution: PATIENCE! Discipline helps too. Also, trust in the process.
Social Pain — studies show we nd it uncomfortable to go against the
crowd even if the view is wrong. When we do, it can trigger emotional
fear.
“Doing something di erent from the crowd is the investment equivalent
of seeking out social pain. As a contrarian investor, you buy the stocks
that everyone else is selling, and sell the stocks that everyone else is
buying. This is social pain. The psychological results suggest that
following such a strategy is really like having your arm broken on a
regular basis—not fun! Fortunately, although painful, a strategy of being
contrarian is integral to successful investment. As Sir John Templeton
put it, “It is impossible to produce superior performance unless you do
something di erent from the majority,” or as Keynes pointed out “The
central principle of investment is to go contrary to the general opinion
on the grounds that if everyone agreed about its merits, the investment
is inevitably too dear and therefore unattractive.””
Groupthink — when the desire to conform is so high that the group’s
decision-making su ers immensely. It spirals to the point that those
with opposing views are shunned, leaving only those that share the
same views. The eight symptoms of groupthink are:
1. The Illusion of Invulnerability — blind to overoptimism and
extreme risks. HOME ABOUT LIBRARY TOOLS
2. Collective Rationalization — blind to con rmation bias and
conservatism — discount all discon rming evidence and fail to
change their minds.
3. Belief in Inherent Morality — see their view as correct, so its
morally and ethically right.
4. Stereotyped Views of Out-Groups — give negative stereotypes of all
non-conforming groups.
5. Direct Pressure of Dissenters — vocal doubters are silenced.
6. Self-Censorship — other doubters keep quiet themselves out of
fear of retribution.
7. The Illusion of Unanimity — views are seen as unanimous.
8. Mind Guards — con rmation bias is used as a lter to protect the
group from discon rming evidence.

Introspection Bias — we believe we know ourselves better than we

actually do.
Fundamental Attribution Error — we tend to blame other people’s
actions on their behavior while blaming our own actions on external
factors.
We all want to think we’re contrarian, independent thinkers, or the
exception to the rule. Being truly contrarian is di cult, not only because
of conformity but because you’re guaranteed to initially look wrong
while everyone else looks right (assuming you’re eventually proved
right).
The solution: courage, critical thinking, and perseverance.
Michael Steinhardt: “The hardest thing over the years has been having
the courage to go against the dominant wisdom of the time, to have a
view that is at variance with the present consensus and bet that view.”
Joel Greenblatt: “You can’t be a good value investor without being an
independent thinker—you’re seeing valuations that the market is not
appreciating. But it’s critical that you understand why the market isn’t
seeing the value.”
Ben Graham: “If you believe that the value approach is inherently sound
then devote yourself to that principle. Stick to it, and don ’t be led astray
by Wall Street’s fashions, illusions and its constant chase after the fast
dollar. Let me emphasize that it does not take a genius to be a
successful value analyst, what it needs is, rst, reasonably good
intelligence; second, sound principles of operation; and third, and most
important, rmness of character.
Loss Aversion — we hate losses about twice as much as we enjoy gains.
Or losses loom larger than gains.
A short-term focus makes loss aversion worse, since the randomness of
markets in the short term can deliver brief paper losses at anytime.
Also, constantly checking your portfolio means you’re more likely to
notice said paper losses. So stop constantly checking your portfolio!
Disposition E ect — the tendency to sell winning investments and hold
on to losing investments.
Terry Odean studied investor brokerage accounts. He found that
investors held losing stocks longer than winning HOME
stocks, are almost
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as likely to sell winners than hold losers, and that the sold winners
outperformed the held losers. Any number of biases – overoptimism,
overcon dence, sunk cost, self-attribution — can be behind it. Simply,
we hold on in the hopes of a recovery.
Also, professional investors aren’t much better. Andrea Frazzini found
that the average pros are 1.2 times as likely to sell winners than hold
losers. The worst performing pros were no better than individual
investors.
Endowment E ect — we put a higher value on things after we own it
than before.
Status Quo Bias — we prefer things stay the same and show it by doing
nothing.
Believing something is worth more than the current asking price and a
bias towards inactions result in a natural reluctance to sell.
Knowing when to sell is one of the hardest, yet most important parts of
investing.
Process over Outcome!
Casinos have a natural advantage thanks to their process. They survive
by o ering games of chance that are ever so slightly tilted in their favor.
They’ve built their business on a process that will win out over
thousands of spins of the roulette wheel, rolls of the dice, or pulls of the
slot machine. Time is a key ingredient to their process. In the short
term, the casino will lose on some of those spins, rolls, or pulls. They
fully expect that a few patrons will beat the odds and come out ahead. A
casino’s process is built on looking “wrong” in the short term while being
“right” in the long run. Doing so guarantees a good outcome in the long
run.
Ben Graham on process: “I recall to those of you who are bridge players
the emphasis that bridge experts place on playing a hand right rather
than on playing it successfully. Because, as you know, if you play it right
you are going to make money and if you play it wrong you lose money—
in the long run. There is a beautiful little story about the man who was
the weaker bridge player of the husband-and-wife team. It seems he bid
a grand slam, and at the end he said very triumphantly to his wife “I saw
you making faces at me all the time, but you notice I not only bid this
grand slam but I made it. What can you say about that?” And his wife
replied very dourly, “If you had played it right you would have lost it.””
So focus on the things you can control. No investment process is
perfect. It will not produce good results every single time. A good
process, that exploits edges, delivers bad breaks sometimes but will win
out if given enough time. Good behavior is key with time.
Outcome Bias — we tend to judge past decisions based on the quality
of the outcome rather than the quality of the decision.
Every decision has four possible results: good decision/good outcome
(deserved success), good decision/bad outcome (bad break), bad
decision/good outcome (dumb luck), bad decision/bad outcome (poetic
justice).
 A hyper-focus on outcomes leads to general stupidity — show higher
loss aversion, embracing certainty, embrace noise, and follow the herd.
“Unfortunately, focusing on process and its long-term bene ts won’t
necessarily help you in the short term. During periods
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underperformance, the pressure always builds to change your process.
However, a sound process is capable of generating poor results, just as
a bad process can generate good results. Perhaps we would all do well
to remember the late great Sir John Templeton’s words, “The time to
re ect on your investing methods is when you are most successful, not
when you are making the most mistakes, ” or indeed Ben Graham’s
exultation, “The value approach is inherently sound…devote yourself to
that principle. Stick to it, and don ’t be led astray.””
Knowledge is not enough to improve behavior. Simply, knowing every
behavioral bias does not equate to better behavior. Changed behavior
requires changes in habits. Setting simple rules help too. Changing
habits work much like compounding, small gradual improvements over
time pay o in big ways. A focus on process is what produces gradual
improvement.

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